Structural Changes in the Indian Economy after liberalization | ISC Class 11 Economics Notes

This note covers the structural changes in the Indian economy after liberalisation: why economic reforms were introduced in 1991, the meaning, need, significance and features of liberalisation, privatisation and globalisation, the meaning of disinvestment, and the significance and limitations of the reform process for India.

Why were economic reforms introduced in India in 1991?

After four decades of planned development, India had built a strong industrial base and become largely self-sufficient in food grains, yet a major segment of the population still depended on agriculture for its livelihood.

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, and foreign exchange reserves, generally maintained to import petroleum and other essential items, dropped to levels not sufficient for even a fortnight. The crisis was further compounded by rising prices of essential goods.

The roots of this crisis lay in the inefficient management of the economy through the 1980s. Government expenditure consistently exceeded its revenue, and this gap was financed by borrowing rather than by raising sufficient taxation or public sector income.

Imports grew at a high rate without a matching growth of exports, so the gap between the two widened.

In the late 1980s, government expenditure began to exceed revenue by such large margins that meeting this gap through borrowing became unsustainable.

There was also not enough foreign exchange to pay the interest owed to international lenders, and no country or international funder was willing to lend to India further.

India approached the International Bank for Reconstruction and Development (the World Bank) and the International Monetary Fund (IMF), and received $7 billion as a loan to manage the crisis.

In exchange, these agencies expected India to liberalise and open up the economy by removing restrictions on the private sector, reducing the role of government in many areas, and removing trade restrictions between India and other countries.

India agreed to these conditionalities and announced the New Economic Policy (NEP).

What was the New Economic Policy of 1991?

The New Economic Policy consisted of wide-ranging economic reforms. Its thrust was towards creating a more competitive environment in the economy and removing barriers to the entry and growth of firms. This set of policies can broadly be classified into two groups.

Definition: Stabilisation measures. "Stabilisation measures are short-term measures, intended to correct some of the weaknesses that have developed in the balance of payments and to bring inflation under control." In simple words, there was a need to maintain sufficient foreign exchange reserves and keep rising prices under control.

Definition: Structural reform measures. "Structural reform policies are long-term measures, aimed at improving the efficiency of the economy and increasing its international competitiveness by removing the rigidities in various segments of the Indian economy."

The government's structural reform policies fell under three broad heads: liberalisation, privatisation and globalisation, commonly referred to together as the LPG reforms. Each is examined below.

What is liberalisation and what did it mean for the Indian economy?

Rules and laws aimed at regulating economic activities had, over time, become major hindrances to growth and development. Liberalisation was introduced to put an end to these restrictions and open various sectors of the economy.

A few liberalisation measures had already been introduced in the 1980s in areas such as industrial licensing, export-import policy, technology upgradation, fiscal policy and foreign investment, but the reforms initiated in and after 1991 were more comprehensive.

Deregulation of the industrial sector

In India, regulatory mechanisms had been enforced through industrial licensing (requiring government permission to start a firm, close a firm, or decide how much to produce), restrictions keeping the private sector out of many industries, reservation of some goods for small-scale industries, and controls on the price and distribution of selected industrial products.

The reforms removed many of these restrictions: industrial licensing was abolished for almost all products except a short list, namely alcohol, cigarettes, hazardous chemicals, industrial explosives, electronics, aerospace, and drugs and pharmaceuticals.

The only industries now reserved for the public sector are part of atomic energy generation and some core activities in railway transport.

Many goods earlier reserved for small-scale industries have since been dereserved, and in most industries the market now determines prices.

Financial sector reforms

The financial sector, comprising commercial banks, investment banks, stock exchanges and the foreign exchange market, is regulated in India by the Reserve Bank of India (RBI), which decides how much money banks can keep with themselves, fixes interest rates, and governs lending to various sectors.

One major aim of financial sector reform was to reduce the role of the RBI from regulator to facilitator, allowing the financial sector to take many decisions without consulting the RBI.

The reforms led to the establishment of private sector banks, Indian as well as foreign, and the foreign investment limit in banks was raised to around 74 per cent.

Banks meeting certain conditions were given freedom to open new branches without RBI approval, though certain managerial aspects have been retained with the RBI to safeguard account-holders and the nation.

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

Tax reforms

Tax reforms concern the government's taxation and public expenditure policies, together known as fiscal policy.

Since 1991, there has been a continuous reduction in taxes on individual incomes, as high rates of income tax were felt to encourage tax evasion; it is now widely accepted that moderate income tax rates encourage savings and voluntary disclosure of income.

Corporation tax, earlier very high, has been gradually reduced. Indirect taxes have also been reformed to help establish a common national market.

In 2016, the Constitution was amended to empower state governments and the Union government to impose the Goods and Services Tax (GST), expected to generate additional revenue, reduce tax evasion, and create "one nation, one tax and one market".

Many procedures have also been simplified and rates substantially lowered to encourage better compliance.

Foreign exchange reforms

The first important reform in the external sector was made in the foreign exchange market.

In 1991, as an immediate measure to resolve the balance of payments crisis, the rupee was devalued against foreign currencies, which increased the inflow of foreign exchange and set the tone for freeing the rupee's value from government control.

Now, more often than not, markets determine exchange rates based on the demand and supply of foreign exchange.

Trade and investment policy reforms

Liberalisation of the trade and investment regime aimed to increase the international competitiveness of Indian industry and to promote the inflow of foreign investment and technology.

To protect domestic industries, India had earlier followed a regime of quantitative restrictions on imports, enforced through tight import controls and high tariffs; these policies had reduced efficiency and competitiveness and slowed the manufacturing sector.

Trade policy reforms aimed at dismantling quantitative restrictions on imports and exports, reducing tariff rates, and removing licensing procedures for imports.

Import licensing was abolished except for hazardous and environmentally sensitive industries, and quantitative restrictions on imports of manufactured consumer goods and agricultural products were fully removed from April 2001.

Export duties were removed to improve the competitive position of Indian goods internationally.

What is privatisation, and what is disinvestment?

Definition: Privatisation. "It implies shedding of the ownership or management of a government owned enterprise." Government companies are converted into private companies in two ways: by withdrawal of the government from ownership and management of public sector companies, or by outright sale of public sector companies.

Definition: Disinvestment. "Privatisation of the public sector enterprises by selling off part of the equity of PSEs to the public is known as disinvestment." Its stated purpose was mainly to improve financial discipline and facilitate modernisation, and to utilise private capital and managerial capabilities to improve PSU performance.

Every year the government fixes a target for disinvestment of public sector enterprises (PSEs). In 1991-92 the target was to mobilise ₹2,500 crore, and the government actually mobilised ₹3,040 crore more than this target. By 2022-23, the government was able to mobilise about ₹46,000 crore through disinvestment.

Why was privatisation of public sector enterprises needed?

Public sector enterprises had been set up to provide infrastructure and direct employment and to make quality goods reach the masses at a nominal cost. Over time, however, their income was not high enough to meet the government's growing expenditure, and losses of such enterprises had to be met out of the public budget.

Privatisation was therefore seen as a way of reducing the role of the government in many areas and opening these enterprises to the private sector, so that private capital and managerial capabilities could be used to improve their performance.

The government also envisaged that privatisation could provide a strong impetus to the inflow of foreign direct investment (FDI).

At the same time, the government tried to improve the efficiency of public sector units without selling them, by giving them autonomy in taking managerial decisions.

What are the features of privatisation?

1. Transfer of ownership: the government withdraws from ownership of a public sector company, so that it becomes a private company.
2. Transfer of management: the government may withdraw from the management of an enterprise even where ownership is not fully sold.
3. Outright sale: a public sector company may be sold outright to private owners.
4. Disinvestment: part of the equity of a public sector enterprise is sold to the public, which brings in private shareholders.
5. Greater autonomy for PSEs: enterprises that remain in the public sector are given greater financial, managerial and operational freedom to run efficiently and raise profits.
6. Inflow of private capital and FDI: private capital and managerial capability are brought in, and foreign direct investment is encouraged.

What is the significance of privatisation?

Privatisation is expected to improve financial discipline in enterprises and facilitate their modernisation. It allows private capital and managerial capabilities to be used for better performance, and it gives a strong impetus to the inflow of foreign direct investment.

For enterprises retained in the public sector, the grant of greater autonomy is meant to infuse professionalism and help them compete more effectively in a liberalised global environment.

What is globalisation and what are its main features?

Definition: Globalisation. Globalisation "is generally understood to mean integration of the economy of the country with the world economy," though it is described as a complex phenomenon involving the creation of networks and activities transcending economic, social and geographical boundaries, so that events happening far away can influence what happens in India.

Outsourcing

Outsourcing is one of the important outcomes of globalisation. In outsourcing, a company hires regular services, mostly from other countries, that were previously provided internally or from within the country, such as legal advice, computer services, advertisement and security.

Outsourcing has intensified because of the growth of fast modes of communication, particularly Information Technology (IT).

Services such as voice-based business processes (popularly known as BPO or call centres), record keeping, accountancy, banking services, music recording, film editing, book transcription, clinical advice and even teaching are being outsourced by companies in developed countries to India.

The low wage rates and availability of skilled manpower in India have made it a destination for global outsourcing in the post-reform period.

The World Trade Organisation

The World Trade Organisation (WTO) was founded in 1995 as the successor organisation to the General Agreement on Trade and Tariff (GATT), which was established in 1948 with 23 countries as the global trade organisation administering all multilateral trade agreements.

The WTO is expected to establish a rule-based trading regime in which nations cannot place arbitrary restrictions on trade; its purpose is also to enlarge production and trade of services, ensure optimum utilisation of world resources, and protect the environment.

The WTO agreements cover trade in goods as well as services, facilitating international trade through the removal of tariff and non-tariff barriers and providing greater market access.

As an important member, India has kept its commitments towards liberalisation of trade by removing quantitative restrictions on imports and reducing tariff rates.

What has been the significance of the reforms for the Indian economy?

The growth of an economy is measured by the Gross Domestic Product (GDP). Post-1991 India witnessed rapid growth in GDP on a continual basis for about two decades, rising from 5.6 per cent during 1980-91 to 9.4 per cent during 2021-22.

During the reform period, the growth of agriculture declined overall, the industrial sector showed fluctuation, and the growth of the service sector rose, indicating that GDP growth has mainly been driven by the service sector.

There was a setback in growth rates of different sectors during 2012-13; agriculture recorded a high growth rate during 2013-14 but small growth in 2021-22; the service sector continued to witness growth higher than overall GDP growth during 2007-22; and the industrial sector, after a steep decline during 2012-13, showed continuous positive growth in subsequent years.

The opening of the economy has led to a rapid increase in foreign direct investment and foreign exchange reserves, and India is one of the largest foreign exchange reserve holders in the world.

Since 1991, India has been seen as a successful exporter of auto parts, pharmaceutical goods, engineering goods, IT software and textiles, and rising prices have also been kept under control.

Advantages of liberalisation, privatisation and globalisation

Some scholars argue that globalisation should be seen as an opportunity in terms of greater access to global markets, high technology, and an increased possibility for large industries of developing countries to become important players in the international arena.

The reforms are credited with removing many restrictive rules and laws that had hampered growth, opening the economy to competition, encouraging private sector banks and foreign investment, simplifying taxation, and expanding India's role as a global outsourcing destination and a successful exporter in several industries.

Limitations and criticisms of the reform process

Other critics argue that globalisation is a strategy of developed countries to expand their own markets, compromising the welfare and identity of people in poorer countries, and that market-driven globalisation has widened economic disparities among nations and people.

Within India, the reform process has been criticised for not adequately addressing basic problems in employment, agriculture, industry, infrastructure development and fiscal management.

1. Growth and employment: although the GDP growth rate rose in the reform period, reform-led growth has not generated sufficient employment opportunities.
2. Agriculture: public investment in infrastructure such as irrigation, power, roads, market linkages and research has fallen, while partial removal of fertiliser subsidy has raised the cost of production, severely affecting small and marginal farmers; reduced import duties and lifted quantitative restrictions have increased competition from imports.
3. Industry: industrial growth has slowed because of cheaper imports and inadequate investment in infrastructure, including power supply, leaving domestic manufacturers facing stiff competition.
4. Disinvestment: critics point out that the assets of PSEs have been undervalued and sold to the private sector, causing a substantial loss to the government, and that disinvestment proceeds are often used to offset revenue shortages rather than for developing PSEs or social infrastructure.
5. Fiscal policy: tax reductions aimed at raising revenue and curbing evasion have not resulted in higher tax revenue, while tariff reductions and tax incentives to attract foreign investment have further reduced the scope for raising revenue, with a negative impact on developmental and welfare expenditure.

Some studies argue that the crisis of the early 1990s was itself an outcome of deep-rooted inequalities in Indian society, and that the reform policies, framed with externally advised policy packages, have further aggravated these inequalities by concentrating income growth in select services such as telecommunication, information technology, finance, entertainment, travel, hospitality, real estate and trade, rather than in agriculture and industry, which provide livelihoods to millions of people.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it. They are collected here for wider reading only.

What is the Navratna, Maharatna and Miniratna policy?

To improve efficiency, infuse professionalism and enable public sector enterprises to compete more effectively in a liberalised global environment, the government identifies select PSEs and declares them as maharatnas, navratnas and miniratnas, giving them greater financial, managerial and operational autonomy to run efficiently and raise profits.

Many of these profitable PSEs were originally formed during the 1950s and 1960s, when self-reliance was an important element of public policy, to provide infrastructure and direct employment and make quality end-products available at a nominal cost.

Some scholars allege that rather than enabling these enterprises to expand and become global players, the government partly privatised them through disinvestment; more recently, the government has decided to retain many of them in the public sector so that they can expand globally and raise resources from financial markets themselves.

What are strategic sale, minority sale, bilateral trade and multilateral trade?

Students sometimes encounter two related terms used alongside privatisation. A strategic sale transfers a controlling stake and management control of a PSU to a private buyer, while a minority sale involves the government selling less than 50 per cent of its equity while retaining management control.

Similarly, trade can be conducted on a bilateral basis, between two countries, or a multilateral basis, among many countries through forums such as the WTO. These distinctions are commonly tested alongside the main features of the reform process.

Glossary

• Liberalisation — removing government rules and restrictions that regulated and controlled economic activity, so as to open sectors of the economy to competition.
• Privatisation — shedding of the ownership or management of a government-owned enterprise, by withdrawal of government control or by outright sale.
• Globalisation — the integration of a country's economy with the world economy through networks of trade, investment, technology and services.
• Disinvestment — selling off part of the government's equity in public sector enterprises to the public.
• New Economic Policy (NEP) — the wide-ranging set of reforms announced by India in 1991 under conditions set by the World Bank and IMF.
• Balance of payments — a record of a country's transactions with the rest of the world, whose crisis in 1991 triggered the reforms.
• Stabilisation measures — short-term measures to correct balance of payments weaknesses and control inflation.
• Structural reform measures — long-term measures to improve efficiency and competitiveness by removing economic rigidities.
• Industrial licensing — the requirement of government permission to start a firm, close a firm, or decide how much to produce, mostly abolished after 1991.
• Quantitative restrictions — limits on the quantity of goods that may be imported or exported, largely dismantled after 1991.
• Tariff — a tax imposed on imported or exported goods.
• Non-tariff barriers — restrictions on trade other than tariffs, such as quotas or standards, used to limit market access.
• Outsourcing — hiring services from an external source, often in another country, that were previously provided internally.
• World Trade Organisation (WTO) — the body founded in 1995, successor to GATT, that administers multilateral trade agreements.

Common errors and misconceptions

• Misconception: liberalisation and privatisation mean the same thing. Correct: liberalisation removes government restrictions on economic activity in general, while privatisation specifically shifts ownership or management of enterprises from government to private hands.
• Misconception: disinvestment always means complete transfer of ownership. Correct: disinvestment is the sale of part of the government's equity in a PSE; it need not transfer full ownership or control.
• Misconception: globalisation refers only to foreign trade in goods. Correct: globalisation is a wider integration of the economy with the world economy, including capital flows, technology and services, as seen in outsourcing and WTO membership.
• Misconception: industrial licensing was abolished for every industry after 1991. Correct: a short list of industries, including alcohol, cigarettes, hazardous chemicals, industrial explosives, electronics, aerospace, and drugs and pharmaceuticals, still require licensing.
• Misconception: the RBI stopped regulating banks after financial sector reforms. Correct: the RBI's role changed from regulator to facilitator, but it retained certain managerial safeguards to protect account-holders and the nation.
• Misconception: the reforms benefited all sectors of the economy equally. Correct: the service sector has grown fastest, while agricultural growth has generally declined and industrial growth has slowed due to cheaper imports and inadequate infrastructure investment.
• Misconception: the WTO and GATT are the same organisation founded in the same year. Correct: GATT was established in 1948, and the WTO was founded in 1995 as its successor organisation.

Exam-style questions with model answers

Q1. State the meaning of disinvestment. [2 marks]

1. Disinvestment is the privatisation of public sector enterprises by selling off part of their equity to the public.
2. The stated purpose is mainly to improve financial discipline and facilitate modernisation of the enterprises.

Q2. Define privatisation. [2 marks]

1. Privatisation implies shedding of the ownership or management of a government owned enterprise.
2. It may happen by withdrawal of the government from ownership and management, or by outright sale of a public sector company.

Q3. State any two features of liberalisation introduced in the industrial sector after 1991. [4 marks]

1. Industrial licensing was abolished for almost all products, except a short list including alcohol, cigarettes, hazardous chemicals, industrial explosives, electronics, aerospace, and drugs and pharmaceuticals.
2. The only industries reserved for the public sector are part of atomic energy generation and some core activities in railway transport.
3. Many goods earlier reserved for small-scale industries have been dereserved.
4. In most industries, the market has been allowed to determine prices.

Q4. Explain the need for privatisation of public sector enterprises in India. [4 marks]

1. Income from public sector undertakings was not high enough to meet the government's growing expenditure, and their losses had to be met out of the public budget.
2. Privatisation was meant to reduce the role of the government in many areas and open these enterprises to the private sector.
3. Private capital and managerial capabilities could be used to improve the performance of the enterprises.
4. The government envisaged that privatisation could give a strong impetus to the inflow of foreign direct investment.

Q5. Explain the features of privatisation. [4 marks]

1. Ownership of a government company is transferred to private hands, so that it becomes a private company.
2. The government may withdraw from the management of a public sector company, or sell the company outright.
3. Part of the equity of a public sector enterprise may be sold to the public through disinvestment.
4. Enterprises retained in the public sector are given greater financial, managerial and operational autonomy.

Q6. Explain the significance of liberalisation, privatisation and globalisation for the Indian economy. [8 marks]

1. Liberalisation removed restrictive rules and laws such as industrial licensing, opened sectors to private firms, and allowed the market to determine prices in most industries.
2. Financial sector reforms reduced the RBI's role from regulator to facilitator, allowed private Indian and foreign banks, and permitted foreign institutional investors into Indian financial markets.
3. Tax reforms lowered income tax and corporation tax rates, simplified procedures, and the GST was expected to create one nation, one tax and one market.
4. Trade reforms dismantled quantitative restrictions, cut tariffs and removed export duties, improving the competitive position of Indian goods.
5. Privatisation and disinvestment were meant to improve financial discipline, facilitate modernisation and bring in private capital and foreign direct investment.
6. Globalisation integrated the Indian economy with the world economy, and outsourcing brought services such as BPO, accountancy and record keeping to India because of low wages and skilled manpower.
7. Foreign investment rose from about US$100 million in 1990-91 to about US$23 billion in 2022-23, and foreign exchange reserves from about US$6 billion to about US$646 billion in 2023-24.
8. India became a successful exporter of auto parts, pharmaceutical goods, engineering goods, IT software and textiles, and GDP growth rose from 5.6 per cent in 1980-91 to 9.4 per cent in 2021-22.

Q7. Explain the main features of globalisation. [8 marks]

1. Globalisation means integration of the country's economy with the world economy, creating networks and activities that cross economic, social and geographical boundaries.
2. Outsourcing is one of its important outcomes: a company hires regular services from external sources, mostly in other countries, that were earlier provided internally.
3. Services such as voice-based business processes, record keeping, accountancy, banking, music recording, film editing, clinical advice and teaching are outsourced to India.
4. Fast modes of communication, particularly information technology, have intensified outsourcing.
5. Low wage rates and skilled manpower have made India a destination for global outsourcing.
6. The WTO, founded in 1995 as successor to GATT, aims at a rule-based trading regime without arbitrary restrictions on trade.
7. WTO agreements cover goods and services and seek to remove tariff and non-tariff barriers and give greater market access.
8. India, as an important member, removed quantitative restrictions on imports and reduced tariff rates to keep its commitments.

Q8. Evaluate the reform process in India, bringing out its limitations. [8 marks]

1. Although GDP growth rose in the reform period, reform-led growth has not generated sufficient employment opportunities.
2. In agriculture, public investment in irrigation, power, roads, market linkages and research has fallen, and partial removal of fertiliser subsidy has raised costs for small and marginal farmers.
3. Reduced import duties and lifted quantitative restrictions have exposed Indian farmers to increased international competition, and a shift to cash crops has put pressure on food grain prices.
4. Industrial growth has slowed because of cheaper imports and inadequate investment in infrastructure such as power supply.
5. Critics say the assets of PSEs have been undervalued and sold to the private sector, and disinvestment proceeds are used to offset revenue shortages rather than to develop PSEs or social infrastructure.
6. Tax reductions have not raised tax revenue, while tariff cuts and tax incentives to foreign investors have reduced the scope for raising revenue, hurting welfare expenditure.
7. Critics argue globalisation is a strategy of developed countries to expand their markets, and that market-driven globalisation has widened disparities among nations and people.
8. Growth has been concentrated in select services such as telecommunication, information technology, finance, entertainment, travel and hospitality, real estate and trade, rather than in agriculture and industry.

Key takeaways

• The 1991 balance of payments crisis, with falling foreign exchange reserves and rising prices, led India to adopt the New Economic Policy.
• The reforms fell under stabilisation measures, which were short-term, and structural reform measures, which were long-term.
• Liberalisation removed restrictions such as industrial licensing and opened the industrial, financial, tax, foreign exchange and trade sectors.
• Privatisation means shedding government ownership or management of enterprises, while disinvestment means selling part of a PSE's equity to the public.
• Privatisation was needed to reduce the government's role, bring in private capital and managerial capability, and attract foreign direct investment.
• Globalisation integrates the Indian economy with the world economy through outsourcing, foreign investment and WTO membership.
• The GDP growth rate rose substantially after 1991, driven mainly by the service sector, while agricultural growth generally declined.
• Critics argue the reforms have widened disparities, benefiting select services more than agriculture and industry, which support most livelihoods.

Test yourself

What immediate event triggered the economic reforms of 1991?

A balance of payments crisis, in which foreign exchange reserves fell to levels insufficient to finance even a fortnight's imports.

Which two international agencies gave India a loan during the 1991 crisis, and how much?

The World Bank and the International Monetary Fund gave India a loan of $7 billion to help manage the crisis.

Name two industries where industrial licensing still applies after liberalisation.

Any two of alcohol, cigarettes, hazardous chemicals, industrial explosives, electronics, aerospace, or drugs and pharmaceuticals.

What change took place in the RBI's role after financial sector reforms?

The RBI's role changed from a regulator to a facilitator of the financial sector, though some managerial safeguards remained with it.

What does disinvestment mean?

Selling off part of the government's equity in a public sector enterprise to the public, to improve financial discipline and modernisation.

Why was privatisation of public sector enterprises needed?

Their income was too low to meet growing government expenditure, and private capital and managerial capability were expected to improve their performance and attract foreign direct investment.

When was the WTO founded, and what organisation did it succeed?

The WTO was founded in 1995 as the successor to the General Agreement on Trade and Tariff (GATT), established in 1948.

Give one reason why agriculture has not benefited much from the reforms.

Public investment in agricultural infrastructure, such as irrigation and research, has fallen, while removal of fertiliser subsidy raised costs for small farmers.