After forty years of planned development after independence, India was able to achieve a strong industrial base and became self-sufficient in the production of food grains. In 1991, a crisis in the balance of payments led to the introduction of economic reforms in India.

In 1991, India met with an economic crisis relating to its external debt. The government was not able to make repayments on its borrowings from abroad. Foreign exchange reserves, which are maintained to import petrol and other important items, dropped to levels that were not sufficient for even a fortnight. The crisis was further compounded by rising prices of essential goods.

The economic liberalization of 1991 was initiated by the then Indian Prime Minister, Mr. P. V. Narasimha Rao and and Finance Minister, Mr. Manmohan Singh in response to a balance of payments crisis being faced by India. The new economic framework adopted by the government did away with the Licence Raj (investment, industrial and import licensing) system and ended many public monopolies.

The policy aimed at allowing foreign direct investment (FDI) in many sectors of the economy. Even though the foreign direct investment ceiling was removed by the government in 1991, it was only in 1996 that foreign investors started showing confidence in the Indian economy and large sectors saw the inflow of foreign capital.

Background

The government generates funds from various sources such as taxation, running of public sector enterprises, etc. When expenditure is more than income, the government borrows to finance the deficit from banks, people within the country and from international financial institutions.

Development policies required that even though the revenues were very low, the government had to overshoot its revenue to meet problems like unemployment, poverty and population explosion. The continued spending on development programmes of the government did not generate additional revenue.

In the late 1980s, government expenditure began to exceed its revenue by such large margins that meeting the expenditure through borrowings became unsustainable. Prices of many essential goods rose sharply. Imports grew at a very high rate without matching growth of exports.

India approached the International Bank for Reconstruction and Development (IBRD), popularly known as World Bank and the International Monetary Fund (IMF), and received $7 billion as loan to manage the crisis. For availing the loan, these international agencies expected India to liberalize and open up the economy by removing restrictions on the private sector, reduce the role of the government in many are as and remove trade restrictions between India and other countries.

India agreed to the conditions of World Bank and IMF and announced the New Economic Policy (NEP). The thrust of the policy was towards creating more competitive environment in the economy and removing the barriers to entry and growth of firms. The government initiated a variety of policies which fall under three heads

  1. Liberalization
  2. Privatization
  3. Globalization

The policy is also popularly called LPG model of development.

Liberalization

Liberalization was introduced to open up various sectors of the economy.

Deregulation of Industrial Sector

The reform policies introduced in and after 1991 removed many of the industrial restrictions. Industrial licensing was abolished for almost all but product categories - alcohol, cigarettes, hazardous chemicals, industrial explosives, electronics, aerospace and drugs and pharmaceuticals. The only industries which are now reserved for the public sector are defence equipments, atomic energy generation and railway transport.

Many goods produced by small scale industries have now been de-reserved. In many industries, the market has been allowed to determine the prices.

Financial Sector Reforms

One of the major aims of financial sector reforms is to reduce the role of RBI from regulator to facilitator of financial sector. The reform policies led to the establishment of private sector banks, Indian as well as foreign.

Foreign Institutional Investors (FII) such as merchant bankers, mutual funds and pension funds are now allowed to invest in Indian financial markets.

Tax Reforms

Since 1991, there has been a continuous reduction in the taxes on individual incomes as it was felt that high rates of income tax were an important reason for tax evasion.

Foreign Exchange Reforms

In 1991, as an immediate measure to resolve the balance of payments crisis, the rupee was devalued against foreign currencies. This led to an increase in the inflow of foreign exchange. Now, markets determine exchange rates based on the demand and supply of foreign exchange.

Trade and Investment Policy Reforms

Liberalization of trade and investment regime was initiated to increase international competitiveness of industrial production and also foreign investments and technology into the economy. The trade policy reforms aimed at dismantling of quantitative restrictions on imports and exports, reduction of tariff rates and removal of licensing procedures for imports.

Import licensing was abolished except in case of hazardous and environmentally sensitive industries. Quantitative restrictions on imports of manufactured consumer goods and agricultural products were also fully removed from April 2001. Export duties have been removed to increase the competitive position of Indian goods in the international markets.

Privatization

Privatization implies opening of the door of industrial activities to the private sector which was exclusively reserved for public sector only except nuclear energy and defence. Since basic and heavy industries were strictly under public sector there was no room for competition. The quality of product and services deteriorated due to lack of competition from other companies. So the government decided to allow and encourage the entry of private sector in the areas earlier reserved for public sector only.

Privatization of the public sector undertakings by selling off part of the equity of PSUs to the public is known as disinvestment. The purpose of the sale was mainly to improve financial discipline and facilitate modernization.

The government has also made attempts to improve the efficiency of PSUs by giving them autonomy in taking managerial decisions. For instance, some PSUs have been granted special status as maharatnas, navratnas and miniratnas.

Globalization

Globalization is a process in which attempts are made by the different countries in the world to allow free flow of goods and services, labour technology, investments, etc. India is a member of world trade organization (WTO) which is the nodal agency to promote globalization.

In 1991 industrial policy, India adopted soft attitude towards foreign companies to do their business in India in order to promote competition. It also committed itself to abolish or reduce tariff on import of commodities. On the other hand, India also adopted policies to promote exports.

The government also allowed foreign companies to hold 51 percent share or more in case of their collaboration with Indian companies so that they can function freely and as the owner. This will also facilitate transfer of latest technology into Indian territory.