Unit 12: Economic Reforms - Subjective Questions

Economic reforms refer to a set of policy measures undertaken by a government to improve the efficiency, productivity, and competitiveness of an economy by reducing state control and encouraging market forces.

Circumstances that led to the 1991 reforms:

• Balance of Payments (BoP) crisis: Foreign exchange reserves fell to about two weeks of imports.
• Fiscal deficit: A high fiscal deficit of around 8.5% of GDP strained public finances.
• Rising inflation: Inflation reached nearly 17%, eroding purchasing power.
• Gulf War (1990-91): Sharp rise in oil prices and fall in remittances worsened the crisis.
• Mounting external debt: India was on the verge of defaulting on international obligations.
• Inefficiency of the public sector: Loss-making PSUs and excessive licensing (License Raj) stifled growth.

These pressures forced India to seek IMF assistance and launch the LPG reforms (Liberalisation, Privatisation, Globalisation).

The LPG model stands for Liberalisation, Privatisation, and Globalisation, forming the core of India's 1991 New Economic Policy.

1. Liberalisation:

• Removal of unnecessary controls and restrictions on the economy.
• Abolition of industrial licensing (except a few industries).
• Reduction of tariffs and easing of trade restrictions.
• Deregulation of interest rates and financial markets.

2. Privatisation:

• Transfer of ownership/management from the public to private sector.
• Disinvestment of government stake in Public Sector Undertakings (PSUs).
• Reducing the role of the state in production.

3. Globalisation:

• Integration of the domestic economy with the world economy.
• Encouraging Foreign Direct Investment (FDI) and foreign trade.
• Reduction of import duties and promotion of exports.

Objective: To make the economy more market-oriented, competitive, and globally integrated, improving efficiency and growth.

Financial sector reforms aimed at strengthening banks, capital markets, and financial institutions to improve efficiency and stability.

Key reforms:

• Reduction in statutory pre-emptions: Lowering of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) to free up funds for lending.
• Deregulation of interest rates: Banks given freedom to set most lending and deposit rates.
• Prudential norms: Introduction of capital adequacy norms (Basel standards), income recognition, and asset classification based on the Narasimham Committee recommendations.
• Entry of private and foreign banks: Increased competition in the banking sector.
• Establishment of SEBI: Strengthening regulation of capital markets.
• Introduction of new instruments: Such as commercial papers and certificates of deposit.
• Technology adoption: Core banking, ATMs, and electronic settlement systems.

Impact: Improved profitability, reduced NPAs (initially), and a more robust and transparent financial system.

The Narasimham Committee (1991 and 1998) laid the blueprint for banking and financial sector reforms in India.

Narasimham Committee I (1991) recommendations:

• Reduction of CRR and SLR to release funds for lending.
• Deregulation of interest rates.
• Introduction of prudential norms for income recognition and provisioning.
• Adoption of capital adequacy ratio norms.
• Greater operational autonomy for banks.
• Entry of private sector banks.

Narasimham Committee II (1998) recommendations:

• Strengthening of the banking system through mergers of strong banks.
• Increasing capital adequacy to align with international standards.
• Reduction of Non-Performing Assets (NPAs).
• Improving supervision and creation of an autonomous Board for Financial Supervision.
• Legal reforms for faster debt recovery.

Significance: These recommendations transformed Indian banking into a more competitive, transparent, and financially sound system.

Cash Reserve Ratio (CRR):

• Portion of a bank's total deposits that must be maintained with the RBI in cash.
• No interest is earned on CRR.
• Controls liquidity and inflation in the economy.

Statutory Liquidity Ratio (SLR):

• Portion of deposits banks must maintain in the form of liquid assets like cash, gold, or government securities.
• Held by the bank itself, not with RBI.
• Ensures solvency and channels funds to government borrowing.

Distinction summary:

Effect of reforms: Both CRR and SLR were progressively reduced after 1991. This freed up a larger share of bank funds for productive lending, increasing credit availability and improving bank profitability.

Non-Performing Assets (NPAs) are loans or advances for which the principal or interest payment remains overdue for a period of 90 days or more.

Classification of NPAs:

• Sub-standard assets: NPA for less than or equal to 12 months.
• Doubtful assets: Remained sub-standard for 12 months.
• Loss assets: Identified as uncollectible.

Importance of NPA management:

• Profitability: High NPAs reduce interest income and erode profits.
• Capital adequacy: NPAs require provisioning, locking up capital.
• Lending capacity: Funds stuck in bad loans reduce ability to lend.
• Financial stability: Rising NPAs threaten the health of the banking system.
• Investor confidence: Lower NPAs improve trust and valuation.

Measures for NPA management: SARFAESI Act, Debt Recovery Tribunals, Insolvency and Bankruptcy Code (IBC), and asset reconstruction companies help recover and reduce NPAs.

Agricultural reforms aimed at improving productivity, marketing, and income of farmers while integrating agriculture with market forces.

Major agricultural reforms:

• Reduction of subsidies: Gradual rationalisation of input subsidies on fertilisers, water, and power.
• Trade liberalisation: Removal of restrictions on agricultural exports and imports.
• Market reforms: Reforms in the APMC (Agricultural Produce Market Committee) system to allow direct marketing and reduce middlemen.
• Institutional credit: Expansion of credit through Kisan Credit Cards and priority sector lending.
• Contract farming: Promotion of tie-ups between farmers and agribusiness firms.
• Investment in infrastructure: Irrigation, storage, and cold chains.
• Technology promotion: High-yielding varieties, precision farming, and use of ICT.

Challenges: Fragmented land holdings, dependence on monsoon, and inadequate marketing infrastructure continued to limit gains.

Objective: To make agriculture more remunerative, market-oriented, and competitive.

The New Industrial Policy of 1991 marked a major shift from a controlled economy to a liberalised, market-driven system.

Key reforms:

• Abolition of industrial licensing: Licensing removed for all industries except a few (e.g., defence, atomic energy, hazardous chemicals).
• De-reservation of public sector: Number of industries reserved for the public sector reduced from 17 to a few.
• Removal of MRTP restrictions: The MRTP Act was relaxed, removing limits on large firms' expansion.
• FDI liberalisation: Automatic approval of FDI up to specified limits.
• Foreign technology agreements: Easier access to foreign technology.
• Disinvestment: Reduction of government stake in PSUs.

Impact:

• Increased competition and efficiency.
• Higher industrial growth and productivity.
• Greater inflow of FDI and technology.
• Emergence of a vibrant private sector.

Overall: The reforms ended the License Raj and made Indian industry more competitive and globally integrated.

License Raj refers to the elaborate system of licenses, permits, and regulations that were required to set up and run businesses in India before 1991. Entrepreneurs needed government approval for almost every business decision.

Features of License Raj:

• Compulsory industrial licensing for production and expansion.
• Restrictions on the type and quantity of goods produced.
• Controls on imports and foreign investment.
• Bureaucratic delays and rent-seeking (corruption).

Effects of dismantling License Raj (post-1991):

• Ease of doing business: Entrepreneurs could set up industries without cumbersome approvals.
• Increased competition: New entrants improved efficiency and quality.
• Higher investment: Both domestic and foreign investment increased.
• Innovation and expansion: Firms could expand freely based on market demand.
• Consumer benefits: Wider choice, better quality, and competitive prices.

Conclusion: Removing the License Raj unleashed entrepreneurial energy and was a key driver of India's post-reform industrial growth.

The services sector (IT, telecom, banking, insurance, tourism, etc.) benefited significantly from liberalisation and became the fastest-growing sector.

Key services sector reforms:

• Telecom: Liberalisation, entry of private players, and creation of TRAI as regulator.
• IT and ITeS: Policy support, tax incentives (STPI scheme), and export promotion.
• Banking and insurance: Entry of private and foreign firms; establishment of IRDA.
• Aviation and tourism: Deregulation and private participation.
• FDI: Opening of various service subsectors to foreign investment.

Reasons for services becoming the growth engine:

• Skilled English-speaking workforce enabling IT and BPO exports.
• Low capital requirements compared to manufacturing.
• Global demand for outsourcing and IT services.
• Technological advancement and internet connectivity.
• High contribution to GDP (over 50%) and foreign exchange earnings.

Conclusion: Services now dominate India's GDP and exports, making the sector central to economic growth.

These three components form the pillars of the 1991 reforms.

Liberalisation: Ended the License Raj, deregulated interest rates, and reduced trade barriers.

Privatisation: Government reduced its stake in loss-making PSUs to improve efficiency.

Globalisation: India opened up to foreign capital, technology, and trade, integrating with the world economy.

Conclusion: Together, they transformed India from a closed, controlled economy into a market-oriented, globally connected one.

Capital Adequacy Ratio (CAR), also called Capital to Risk-weighted Assets Ratio (CRAR), measures a bank's available capital as a percentage of its risk-weighted credit exposures.

Formula:

Importance:

• Ensures banks can absorb a reasonable level of losses.
• Protects depositors and promotes stability of the financial system.
• Introduced under Basel norms as part of prudential reforms.

Calculation:

Given capital = ₹90 crore, Risk-weighted assets = ₹1000 crore.

Interpretation: A CAR of 9% means the bank has ₹9 of capital for every ₹100 of risk-weighted assets. This meets the RBI's minimum requirement (currently 9%), indicating the bank is adequately capitalised.

India's 1991 reforms brought significant changes with both benefits and drawbacks.

Positive impacts:

• Higher growth rate: GDP growth accelerated in the post-reform period.
• Increased FDI and foreign exchange reserves.
• Boom in the services sector, especially IT and telecom.
• Greater competition leading to better quality and choice.
• Rise of private entrepreneurship and reduction of the License Raj.
• Integration with global markets and export growth.

Negative impacts:

• Agricultural neglect: Reduced public investment and subsidies hurt farmers.
• Jobless growth: Employment did not grow in proportion to output.
• Rising inequality: Benefits concentrated among urban and skilled sections.
• Regional disparities: Some states advanced faster than others.
• Vulnerability to global shocks due to greater integration.
• Neglect of small industries facing competition from large and foreign firms.

Conclusion: Reforms boosted growth and efficiency but need to be complemented by inclusive policies addressing agriculture, employment, and equity.

Disinvestment refers to the process by which the government sells or liquidates part or all of its stake (equity) in Public Sector Undertakings (PSUs).

Objectives of disinvestment:

• Reduce fiscal deficit by raising revenue.
• Improve efficiency of PSUs through private participation.
• Reduce government burden of managing enterprises.
• Broaden ownership and develop capital markets.
• Fund social and developmental programmes.

Approaches to disinvestment:

• Minority disinvestment: Government sells a minority stake, retaining control (more than 51%).
• Majority disinvestment / Strategic sale: Government sells majority stake along with management control to a strategic partner.
• Complete privatisation: Government sells 100% ownership.
• Offer for Sale (OFS) and IPOs: Selling shares to the public through the stock market.

Conclusion: Disinvestment is a key tool of privatisation, aiming to improve efficiency and mobilise resources, though it must be balanced with strategic and social considerations.

SEBI (Securities and Exchange Board of India) was established in 1988 and given statutory powers in 1992 to regulate the securities market.

Role of SEBI:

• Protecting investors' interests in securities.
• Regulating stock exchanges and market intermediaries.
• Preventing fraudulent and unfair trade practices like insider trading.
• Promoting fair and transparent markets.

Major capital market reforms:

• Establishment of NSE (1994): Introduced screen-based electronic trading.
• Dematerialisation: Shift from physical to electronic (demat) shares reducing fraud.
• Rolling settlement: Faster and safer trade settlement (T+1/T+2).
• Free pricing of shares: Abolition of the Controller of Capital Issues.
• Entry of FIIs: Foreign Institutional Investors allowed to invest.
• Stricter disclosure norms for listed companies.

Impact: These reforms made Indian capital markets more transparent, efficient, liquid, and globally competitive, boosting investor confidence and capital formation.

External sector reforms aimed at integrating India with the global economy and correcting the balance of payments crisis.

Key external sector reforms:

• Devaluation of the rupee (1991): To make exports competitive.
• Move to market-determined exchange rate: Shift from fixed to a managed floating system (LERMS then unified rate).
• Reduction of import tariffs: Peak customs duties reduced substantially.
• Abolition of import licensing for most goods.
• Convertibility: Full current account convertibility and partial capital account convertibility.
• Promotion of exports: EXIM policy, Special Economic Zones (SEZs), and Export Promotion Councils.
• Liberalisation of FDI and FII flows.

Impact:

• Sharp rise in foreign exchange reserves.
• Growth in exports and imports (higher trade-to-GDP ratio).
• Greater integration with world markets.

Conclusion: These reforms transformed India from an inward-looking economy into an increasingly open and globally integrated one.

The three sectors responded differently to economic reforms.

1. Agriculture:

• Slowest growth among the three sectors.
• Reduced public investment and subsidy rationalisation hurt farmers.
• Continued dependence on monsoon and fragmented holdings.
• Declining share in GDP but still employs a large workforce.

2. Industry:

• Moderate growth after removal of License Raj.
• Increased competition and efficiency.
• Manufacturing growth remained below potential; jobless growth a concern.
• Rising FDI and technology inflows.

3. Services:

• Fastest-growing sector and the main growth driver.
• IT, telecom, finance, and BPO boomed.
• Now contributes over 50% of GDP.
• High export earnings and employment for skilled workers.

Comparison summary:

Conclusion: Reforms benefited services the most, while agriculture lagged, creating structural imbalances in growth.

Prudential norms are the standards and guidelines set by the RBI (based on Narasimham Committee and Basel norms) to ensure that banks conduct their business in a safe and sound manner.

Main prudential norms:

• Income recognition: Income should be recognised only when actually realised, not on accrual for NPAs.
• Asset classification: Loans classified as standard, sub-standard, doubtful, or loss assets.
• Provisioning norms: Banks must set aside provisions against potential losses on NPAs.
• Capital adequacy: Maintaining minimum CAR to absorb losses.

Significance:

• Transparency: Reflect the true financial health of banks.
• Stability: Reduce the risk of bank failures.
• Depositor protection: Safeguard public deposits.
• International alignment: Bring Indian banking to global standards.
• Discipline: Encourage prudent lending and risk management.

Conclusion: Prudential norms strengthened the banking system by making it more transparent, resilient, and internationally competitive.

Objectives of economic reforms:

• Overcome the BoP crisis and rebuild foreign exchange reserves.
• Control inflation and reduce fiscal deficit.
• Improve efficiency and productivity through competition.
• Attract foreign investment and technology.
• Integrate with the global economy.
• Promote private sector participation and reduce state control.
• Achieve higher and sustainable economic growth.

Assessment of achievements:

Successes:

• Foreign exchange reserves rose dramatically.
• Higher GDP growth and strong services sector.
• Booming IT, telecom, and financial markets.
• Increased FDI and integration with world markets.

Shortfalls:

• Agriculture remained weak with slow growth.
• Employment generation lagged (jobless growth).
• Rising income and regional inequalities.
• Persistent poverty in certain sections.

Conclusion: Reforms largely succeeded in stabilising the economy and boosting growth, but goals of inclusive and balanced development remain partially unfulfilled.

Foreign Direct Investment (FDI) refers to investment made by a foreign entity to acquire lasting ownership or control (usually 10% or more equity) in a domestic enterprise, involving capital, technology, and management.

FDI reforms in India:

• Automatic route: FDI allowed without prior approval in most sectors up to specified limits.
• Raising sectoral caps: Higher FDI limits in telecom, insurance, defence, retail, etc.
• Simplified procedures and abolition of FIPB for many sectors.
• Ease of doing business initiatives.

Benefits of FDI to the Indian economy:

• Capital inflow: Supplements domestic savings and investment.
• Technology transfer: Access to advanced technology and know-how.
• Employment generation: Creation of jobs in various sectors.
• Managerial expertise: Better management practices and efficiency.
• Export promotion: Integration with global supply chains.
• Infrastructure development: Investment in key infrastructure areas.

Conclusion: FDI reforms transformed India into an attractive investment destination, contributing to growth, technology upgradation, and global integration.