Eco chp1.docx

**NEW ECONOMIC POLICY 1991** 1.1 INTRODUCTION The year 1991 is one of the most significant one in the economic history of India. The economy underwent some major shifts in its policies and structure. Since 1951, when India adopted the Five Year Plans, the economy was functioning as a mixed econom...

**NEW ECONOMIC POLICY 1991** 1.1 INTRODUCTION The year 1991 is one of the most significant one in the economic history of India. The economy underwent some major shifts in its policies and structure. Since 1951, when India adopted the Five Year Plans, the economy was functioning as a mixed economy, with government controlling some of the most strategic industrial sectors. There were several controls of the government over the use of resources by the private sector. These were in the form of industrial licensing, import licensing and controls, foreign exchange regulations, public monopoly in sectors, MRTP Act, control over the banking sector and capital market. The reason why the mixed economic system and the socialistic pattern of economy was followed was because India was an underdeveloped economy, with mass poverty and unemployment. The planners decided that to lift the economy out of this state of underdevelopment, it was necessary that the government controlled and regulated the use of scarce resources and use them for the benefit of the people. The private sector was not given a free hand to operate a purely market oriented economy because it was believed that it would exploit people to achieve its profit oriented goals. The main objective of the planned growth strategy was large scale industrialisation through public sector, control of imports to promote local industries, regulate the financial sector to divert resources to the weaker sections of society and keep private monopoly under check. Though the objectives of the planners were to uplift the poor and create employment and seemed appropriate for the nation, the massive government controls over the nation\'s resources brought in several problems. These were in the form of corruption by public servants, shortage of resources, high cost of production and high prices. India was a high-cost, low efficient economy that couldn\'t compete in the international market. The public sector enterprises played a very significant role in creating employment and providing several goods and services at low cost. However, due to mismanagement of resources, lack of accountability and excessive focus on social objectives, many of these enterprises made losses and became a burden to the taxpayers. Because of all these problems, in 1980s, the government had begun to bring in some measures of liberalisation of the economy from government control. But these measures were small steps and they did not make any significant difference to the way the economy functioned. All this changed in 1991, when certain events forced the government to take the major step of introducing far reaching reform programmes for all sectors of the economy. These reforms are generally referred to as the New Economic Policy, 1991. 1.2 THE RATIONALE OF NEW ECONOMIC POLICY (NEP) 1991 Despite some liberalisation measures introduced in 1980s, there was no major change in the industrial, trade and financial market policies in India. Unlike China, India did not undertake gradual economic reforms to open up the economy to foreign competition, reduce government control over physical and financial resources. The management of the economy by the government became increasingly problematic in terms of efficient use of resources, ultimately resulting in major crises situations in 1990-91. These crises resulted in forcing the government to undertake some bold and drastic reform measures to stabilise the economy and bring in structural reforms. **A. Rationale of NEP 1991** Thus in 1990-91, India faced economic crisis in the following ways and they provided the reasons for the implementation of the New Economic Policy. 1\. **Fiscal Crisis**: The fiscal situation in India had been deteriorating especially since 1980s, due to widening gap between the revenue and expenditure of the government. The long-term trend in the government finances indicated that the revenue generation had been lower than the expenditure requirements, leading to rising fiscal deficit. The worsening of fiscal situation was mainly due to very significant increase in non- development expenditure such as interest payments, defence expenditure, subsidies and so on. As a consequence the fiscal deficit rose to 7.7 percent of GDP in 1990-91. Since the fiscal deficit was financed through borrowings, the internal debt of the central government was 48.6% of GDP in 1990-91. Since the debt has to be serviced, the interest burden of the government rose to 29 percent of revenue expenditure of the Central government in 1990-91. High fiscal deficits in the 1980s were one of the root causes of the crisis of 1991. Reducing the fiscal deficit was an important macroeconomic objective of the New Economic Policy. 2\. **Balance of Payments Crisis**: The Gulf crisis\* of 1990 led to an unprecedented crisis in the balance of payments. The balance of payments crisis reached its peak in the summer of 1991 when the foreign exchange reserves had fallen to about US \$ 1 billion. The payments crisis became evident in 1990-91 when the oil prices increased due to the Gulf war. This resulted in worsening of current account deficit which rose to 9.7 billion US dollars i.e. 3.2% of the GDP in 1990-91. There was also a deterioration in the invisibles account due to lower remittances. A large number of Indians worked in the Gulf region and sent money remittances to India. Due to the Gulf war, many of them lost their jobs and this reduced the remittances to India\'s current account in the balance of payment. Foreign reserves started to decline from \$ 3.1 billion in August 1990 to \$ 896 million in January 1991. The main factor responsible for the sharp fall in reserves was the sharp rise in the imports expenditure due to oil price rise and sharp fall in foreign remittances from Indian workers in the Gulf region. However, the balance of payments crisis of 1990-91 was not simply due to a deterioration on the trade account, it was also due to adverse developments on the capital account reflecting the loss of confidence in the government\'s ability to manage the situation. Political uncertainty in the country, coupled with rising fiscal deficits and rising inflation, also led to loss of international confidence. It was extremely difficult for India to commercially borrow from abroad because the credit rating agencies downgraded India\'s rating. At the same time, there was an outflow of non-resident Indian deposits. Without borrowing and NRI deposits, it was impossible to finance the current account deficit of \$ 9.7 billion in 1990-91. Thus, by June 1991, the balance of payments crisis had become largely a crisis of confidence. This means, absence of confidence in the government\'s ability to manage the balance of payments problem. India was very close to defaulting on international payments. A default is a failure to repay debts, but its consequences are never confined to debt. A default in payments leads to a break down in credit availability and normal payments arrangements. Suppliers become reluctant to sell goods and services and insist on advance payments through banks of their own country. This leads to severe trade disruption which in turn forces severe and prolonged import reduction and leads to shortages, industrial disruptions, severe unemployment and high rate of inflation. All these became a possibility for the Indian economy. 3\. **High Inflationary Pressure**: The wholesale prices in India rose at an annual rate of 8.2 percent during the period 1981-82 to 1993-94. In 1990-91 the rate of inflation crossed double digit mark and stood at 10.2 percent. The inflationary rise in price was due to raising of administered prices (prices determined by the firm or, in this case by the government, on the basis of cost of production and not by the forces of market demand and supply) especially the prices of petroleum products and indirect taxes on commodities. The average annual rates of inflation were quite high between 10 percent and 14 percent till 1994-95. **B. Objectives of NEP 1991** The NEP 1991 brought about major structural changes in the Indian economy. It was a very bold step taken by the then government to reshape the nature of the economy to achieve some significant objectives. Some of which are: 1\. **Economic Stabilisation**: The immediate objective of the NEP 1991 was to manage the crises facing the Indian economy in the form of large fiscal deficit, high rate of inflation and huge balance of payments deficit and bring in economic stability. 2\. **Accelerate Economic Growth**: The long term objective of the NEP 1991 was to bring in major structural changes in the economy to enable India to grow its GDP at a much faster rate than before. These changes would liberalise the economy from several government controls and provide incentives to businesses to invest and produce. The aim was to get the economy out of the slow growth rate trajectory and bring it on par with other Asian countries like, China, Malaysia and South Korea. 3\. **Generation of Employment**: Creating employment and livelihoods for the millions of poor Indians was one of the major objectives of the NEP 1991. With increased investment, both domestic and foreign, it was hoped that many new jobs will be created. 4\. **Reduction in Poverty**: A very large section of India\'s population live in poverty. There are several estimates of the number of people living below the poverty line but the estimates often vary widely. However, it is safe to say that a vast majority of Indians lived in different states of poverty and deprivation before and after Independence. Though poverty alleviation measures were implemented by the government, there was not much change in the condition of the poor in India in the first four decades after Independence. With the implementation of the NEP 1991, it was believed that the only way to lift millions of India\'s poor above the poverty line was through rapid economic growth. As more and more employment opportunities opened up in a globalised and liberalised economy, incidence of poverty would reduce. 5\. **Improve Quality of Life**: A faster rate of GDP growth was considered an essential factor for achieving better quality of lives of people and improve India\'s standing in human development index. 6\. **Globalisation of the Indian Economy**: Since Independence, Indian economy was guided by the objective of self-reliance in its trade policy. Though the objective was appropriate soon after Independence, it was no longer appropriate to follow an inward looking, protectionist trade and investment policy during 1980s and 1990s when the entire world was moving towards a more open and globalised environment. The NEP opened up the economy and liberalised foreign trade and investment policy. India was expected to make the most of its export potential in different sectors, earn foreign exchange and improve its international competitive advantage. Foreign investment was sought to build the economy\'s productive capacity. 7\. **Increase in Capital Formation**: With liberalisation of the private industrial sector, financial markets and FDI policy it was expected that both domestic and foreign capital will be available with ease for investment and capital formation. This will increase productive capacity and lead to economic growth. 8\. **Reduce Government Control**: One of the primary objectives of the NEP 1991 was to reduce direct and indirect government controls over economic assets and activities that were proving to be disadvantageous to private sector investment. With abolition of licensing policy, amendment to the MRTP Act and other liberalisation measures, it was expected that the private sector would have incentive to make investment on a large scale. 9\. **Disinvestment of Public Sector**: The public sector had grown economically unviable, with increased losses, cost escalation and was a drain on the government\'s budget. With the NEP, it was aimed to make public sector more efficient, accountable and competitive. This was sought to be achieved through the policies of privatisation and disinvestment. 10\. **Improve Efficiency and Competitiveness**: The NEP aimed at providing a liberalised economic environment for the Indian industries to be more innovative and efficient. With a globalised economy Indian enterprises would face competition from global firms, would have access to foreign capital and to best practices and technology from abroad. All these factors were expected to bring in more competitiveness in Indian businesses. 1.3 IMPORTANT POLICY CHANGES IN ΝΕΡ 1991 The new government under the Prime Ministership of P.V. Narasimha Rao which assumed office in June 1991, took the following policy measures. Led by the Prime Minister, the then Finance Minister, Dr. Manmohan Singh along with economic advisors like Montek Singh Ahluwalia were the chief formulators of the New Economic Policy 1991. They implemented a combination of macroeconomic stabilisation and structural reforms in industrial and trade policy. Together, the policies are popularly termed as LPG policies as they resulted in liberalisation, privatisation and globalisation of the Indian economy. **A. MACROECONOMIC STABILISATION (DEMAND MANAGEMENT)** These measures are short-term measures aimed at demand management. The objective of such measures was to stabilise the economy through the following: \(1) Control of inflation \(2) Fiscal correction and \(3) Improvement in balance of payments position 1\. **Control of Inflation**: A combination of fiscal and monetary policies were undertaken to bring down the high inflation rate. Fiscal deficit was one of the causes of inflation to before 1991. Fiscal deficit was brought down from 7.7% of GDP in 1990-91 to 4.9% in 1995-96. RBI continued with tight monetary policy aimed at making borrowing costlier by raising Bank Rate, CRR and SLR. It was done to reduce money supply and control inflation. SLR was raised from 38% to 38.5% in September 1990. The CRR was raised to 15% in July 1989. The bank rate was raised to 12 percent in October 1991 to curb excessive liquidity. Later the RBI started to bring down CRR and SLR in a phased manner on the basis of recommendations of the Narasimham Committee. In order to improve the supply position of essential commodities the government had allowed their imports. Thus, the inflation rate was brought down to 8 percent in 1995-96 and further to 4.6 percent in 1996-97. 2\. **Fiscal Correction:** Fiscal reforms were introduced since 1991 to correct the growing fiscal imbalance. To this end, government introduced expenditure reforms to reduce non-productive public expenditure by cutting down subsidies, defence expenditures and administrative expenditures. Government reduced the budgetary support to public sector enterprises and also undertook repayment of old public debt in order to reduce the interest burden. Measures were taken to increase tax revenue through tax reforms. Taxes were rationalised and simplified. In the area of direct taxes the reforms brought in a regime of moderate tax rates. The maximum rate of personal income tax had come down from 56% at the start of the reform to 30% in 1997-98. The rate of corporation tax on Indian companies, which varied from 51.75% to 57.5% in 1991-92 depending upon the nature of the company, had been unified and reduced to 35%. The maximum rate of customs duty, which was as high as 250% before the reforms, had been reduced to 40 percent in 1997-98. In 1994-95, service tax was introduced. All these measures increased tax compliance and increased government\'s tax collection. Therefore, increased tax collection and controlled public expenditure brought about stability in fiscal deficit. 3\. **Balance of Payments Adjustment**: Measures were taken to improve the balance of payments of the country. The rupee was devalued (currency devaluation is a deliberate policy measure to make downward adjustment of the domestic currency against foreign currencies with the objective to encourage exports and discourage imports) by 18 - 19 percent in July 1991. This was followed by the introduction of liberalised exchange rate management system (LERMS) in 1992-93. Under this, a dual exchange rate was fixed under which 40% of foreign exchange was to be surrendered at the official rate and the remaining 60% could be converted at a market determined rate. Subsequently India adopted the unified exchange rate system in 1993-94 with full convertibility in the current account. India moved to managed floating exchange rate system. Efforts were made to increase exports. In order to bring about technological upgrading in the export sector, imports were liberalised. Non-debt creating foreign inflows were encouraged in the form of foreign direct investment and portfolio investments into the country. The above measures helped to improve the balance of payments position of the country. B. STRUCTURAL REFORMS (SUPPLY SIDE MANAGEMENT) These are long-term measures taken to improve the supply side of the economy. They aimed at removing the bottlenecks and obstacles in the growth path of the economy and increase supply of goods and services. These measures were aimed at reforming the structure of the economy. \(1) Industrial reforms \(2) Public sector reforms and disinvestment \(3) Trade and capital flows reforms \(4) Financial sector reforms 1\. **Industrial Sector Reforms**: The industrial development of the country was influenced by Industrial Policy Resolutions of 1948 and 1956. These policy resolutions had helped to build a strong and diversified industrial sector in India. At the same time, the industrial policies had resulted in rising cost, rising industrial sickness and stagnating industrial growth due to excessive government control over industries. Because of these, government started to liberalise the industrial policy measures since 1985. The momentum of industrial sector reforms increased with the announcement of New Industrial Policy in 1991 (NIP). The important industrial sector reforms introduced in July 1991 are the following: \(a) **Abolition of Industrial Licensing**: The new policy abolished industrial licensing for all industries, except 18 industries. At present there are only five industries under compulsory licensing. They are alcohol, cigarettes, hazardous chemicals, electronic aerospace and defence equipment and industrial explosives. There are locational restrictions for industries under which, industries located within 25 kms of the periphery of urban areas having a population of at least 1 million, must obtain an industrial license from the central government, except for those in the following categories: \(i) Non-pollution industries \(ii) Those located in areas designated as \'industrial areas\' \(b) **Permitted foreign investment and foreign technology**: The NIP encouraged foreign direct investment and foreign technology imports in high priority industries. The number of industries eligible for foreign direct investment has been expanded. Initially, FDI was allowed upto 51 percent. Subsequently this limit was raised to 100 percent for many industries. \(c) **Reduced the role of public sector**: The new policy reduced the number of industries reserved for public sector from 17 to 3 at present. The industries that are reserved for public sector at present are (1) atomic energy, (2) substances notified by Department of Atomic Energy and (3) railway transport. Thus core industries like iron and steel, electricity, air transport, etc. and even strategic industry like defence production are opened up for the private sector. \(d) **Removal of MRTP limit**: Under the Monopoly and Restrictive Trade Practices (MRTP) Act large companies with assets of 100 crore and above were not allowed to expand their activities without the government permission. This restricted the growth, expansion and efficiency of such firms. The new policy removed this threshold limit. This eliminated the requirement of prior approval of government for large industrial houses for expansion, establishment of new undertakings, mergers, takeover and amalgamation. The MRTP Act is now replaced by Competition Act, 2002. 2\. **Public Sector Reforms and Disinvestment**: The public sector enterprises constitute a major segment of industrial activity in India. It has provided India with a large and diversified industrial base, generated employment and earned foreign exchange through exports and import substitution. At the same time the performance of public sector enterprises have suffered due to mounting losses, fall in efficiency, causing a drain on the government\'s budget. Since 1991, there have been major changes in the public sector policy in India. Public sector reforms consisted of \'disinvestment\' involving sale of a portion of the government\'s equity in public sector enterprises while retaining majority control with the government attempting to improve the performance of public sector enterprises. Other measures introduced were raising of fresh equity directly by public sector from the market, greater competition from new private enterprises and giving greater financial and operational autonomy to public enterprises. 3\. **Trade and Capital Flows Reforms**: The government took the following reforms in the external sector to open up the Indian economy to foreign competition and foreign investment. \(i) Liberalisation of imports: Import controls were virtually abolished except for some consumer goods. \(ii) Reduction in tariff structure: The peak import duty on non-agricultural products was reduced from more than 300 percent to 150 in 1991-92. It was further lowered to 20% in 2004-05 and to 10% in 2007-08. Import duties have been further brought down as part of WTO agreement. \(iii) Promotion of exports: Various incentives are provided to exporters in the foreign trade policies including duty drawbacks, Export Promotion Capital Goods Scheme (EPCGS) and creation of SEZs. \(iv) Change in exchange rate policy: The exchange rate was allowed to be determined by demand and supply in the foreign exchange market since 1993. This would help to ease the balance of payments problems. The RBI intervenes in the foreign exchange market to reduce excess volatility in the foreign exchange market to stabilise the exchange rate. \(v) Introduced current account convertibility: The government introduced convertibility of the rupee\*, first on trade account, and subsequently on the entire current account in August 1994. This increased the availability of foreign exchange to exporters, importers and for retail users. \(vi) Liberalised capital inflows: The government has liberalised capital inflows in the form of Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). Foreign Portfolio Investors are allowed to invest in all types of securities traded in the primary and secondary markets. Similarly, external commercial borrowings (ECBs)\*\* norms have been liberalised in terms of expanding the list of eligible borrowers and end-use of funds raised through ECBs. 4\. **Financial Sector Reforms**: The financial sector reforms that were introduced by the government since the early 1990s are aimed to make the Indian financial sector strong and transparent. The Indian financial sector consists of banking, insurance and capital market. The government appointed a committee under the chairmanship of M. Narasimha to examine all aspects of financial system in India. The Narasimham Committee submitted its report in December 1991. In 1997, the government appointed a second committee on banking sector reforms under the chairmanship of M. Narasimha. This committee submitted a second report in April 1998. Banking sector reforms are based on the recommendations of these committees. **(A) Banking Sector Reforms** Banking sector reforms were first initiated in 1992 based on the recommendations of Narasimham Committee. The important reforms introduced in the banking sector since 1991 are: \(i) Lowering of SLR: Statutory Liquidity Ratio (SLR) has been reduced gradually. As of April 2024, SLR was 18%. \(ii) Lowering of CRR: The Cash Reserve Ratio (CRR) was reduced gradually from 15 percent in 1991 to 4.5 percent in June 2003. This has released more funds for lending to other sectors. As of April 2024, CRR was 4.50%. \(iii) Deregulation of Interest Rates: Scheduled commercial banks have now the freedom to set interest rates on their deposits. This is expected to bring healthy competition among the banks and encourage their operational efficiency. \(iv) Introduction of Prudential Norms: Prudential norms are related to recognition of income, classification of assets and provisioning of bad debts in accordance with internationally accepted accounting practices. This was done to ensure that the books of the commercial banks reflect their financial position more accurately. \(v) Introduction of Capital Adequacy Norms: Capital adequacy ratio measures a bank\'s capital in relation to its risk-weighted assets. It promotes financial stability. \(vi) Access to Capital Market: Nationalised commercial banks are allowed to access capital market for funds, through public issues. \(vii) Entry of New Private Sector Banks: Government permitted the entry of new private sector banks. This has provided competition to the public sector banks. \(viii) Freedom of Operations: Scheduled commercial banks have been given freedom to open new branches and upgrade extension counters. They are also permitted to close non-viable branches. Bank lending norms have been also liberalised. **(B) Capital Market Reforms** Capital market is the market where medium to long term funds can be raised through debt and equity. Along with reforms in the banking sector, reforms were also introduced in the capital market. The important reforms introduced in the capital market are: \(i) SEBI as Statutory Body: Securities and Exchange Board of India (SEBI) was set up in 1988 and it was made a statutory body in January 1992. SEBI is authorised to regulate all merchant banks on issue activity, lay guidelines and supervise and regulate the working of mutual funds and oversee the working of stock exchanges in India. \(ii) Primary Market Reforms: Companies raising capital in the primary market are required to disclose all information. Companies are allowed to determine the par value of shares issued by them. Stricter norms have been introduced in all aspects of Initial Public Offering (IPO). \(iii) Online Trading and Dematerialised Trading: SEBI has introduced online trading and dematerialised trading. This was expected to lead to reduction in time and cost and elimination of various risks associated with paper based or physical settlement. \(iv) Rolling Settlement: SEBI has introduced rolling settlements from January 2000. Under this system the trading cycle has been shortened to a day and trades are settled within 2 working days. This is expected to increase the efficiency and integrity of the securities market. \(v) Investments by FIIs: Foreign Institutional Investors (FIIs) are allowed to invest in all types of securities traded in the primary and secondary markets. \(vi) Investor Protection: Measures have been taken for the investor protection. For this purpose the Investor Education and Protection Fund (IEPP) has been established in Oct. 2001. \(vii) Derivatives Trading: Trading in equity derivatives was introduced in 2000. There are now four equity derivative products in Indian capital market, namely stock options, stock futures, index futures and index options. \(viii) Establishment of NSE: National Stock Exchange of India (NSE) was set up in November 1992. It started its operations in 1994. It has helped to bring transparency and operational efficiency in the secondary market operations. \(ix) Setting up of National Securities Clearing Corporation (NSCC): The NSCC was set up in 1996. It guarantees all trades on NSE. Thus every trade that takes place is freed from the risk of the counter party defaulting. This has ended the risk of failures leading to a payment crisis. \(x) Strengthening the Government Securities Market: A number of measures were taken to strengthen the government securities market. They are the introduction of the auction system for the sale of government securities, setting up of the Securities Trading Corporation of India and so on. **(C) Insurance Sector Reforms** Insurance sector was the monopoly of the government prior to 1999. Reforms in the insurance sector commenced with the passing of the Insurance Regulatory and Development Authority (IRDA) Act of 1999. The IRDA Act ended the monopoly of the government in the insurance sector. This is done by encouraging private investment in the insurance sector. The IRDA has given licences to a number of private sector companies to do insurance business. The government has raised the foreign equity investment capital in an Indian insurance company from 49 percent to 74 percent under automatic route. Financial sector reforms have led to significant broadening and deepening of financial markets with the introduction of many new instruments and products in banking, insurance and capital markets. The new economic policy has created an encouraging environment for investment and innovation. Indian industries have started to attract foreign portfolio investments and equity participation in new ventures. India has started to experience higher growth rates in the post-reform period. Indian economy is now much more integrated with the world economy.