Introduction to Economic Liberalization in India
As we know that prior to 1991, a host of control systems such as licensing system, foreign exchange control, control on expansion, etc. was imposed on the private sector.
However, owing to this, inefficiencies crept into the system and economic growth was badly hampered. GDP growth rate hit an all-time low. With the aim of reviving the economy, New Economic Policy was introduced in the year 1991. Liberalization forms the foremost element of this policy.
Liberalization refers to the freedom of the economy from direct or physical controls (such as industrial licensing, price control, import license, etc) imposed by the government. It implies greater dependence on the market for making various economic decisions. In other words, it refers to a gradual move from a planned socialist economy towards a market economy.
It is assumed that the greater role of the market increases competitiveness and makes the system more efficient. This fosters the growth process. The success stories of the countries such as Singapore, Korea, and Thailand confirm the role of liberalization in the growth and development process.
Economic Liberalization Measures Followed by India
Let us analyze the liberalization measures followed by India in detail.
Economic Liberalization in India Measures #1
Industrial Sector Reforms
Prior to the reforms of 1991, the private sector played only a secondary role in the process of industrial development. The state directly controlled the private sector. The private sector was allowed entry in only a few industries. Moreover, the limits of production by private entrepreneurs were pre-decided by the government.
In addition, the establishment of new industries or the expansion of existing industries required permission from the government in the form of licensing. The state fully controlled the operations of the private sector, either directly or indirectly. Under the liberalization policy, various reforms were followed in the industrial sector. The following are the major highlights of the industrial sector reforms.
a. Abolition of licensing: Prior to the reforms of 1991, for setting up a new firm or to expand an existing firm, the entrepreneurs had to obtain permission from the government in the form of licenses. Under the new industrial policy in 1991, this system was abolished. In other words, with the industrial reforms, the private players were free to start a new venture without the need to obtain a license.
However, the system of licensing was retained in six industries namely, liquor, cigarette, defense equipment, dangerous chemicals, industrial explosives, and drugs and pharmaceuticals. Besides, the impetus was provided to the private sector in the form of liberal tax laws, tax holidays, abolishment of quotas, etc.
b. Dereservation: With liberalization policy, the number of industries exclusively reserved for the public sector was considerably reduced. The private sector was allowed to operate in the majority of the industries with only 8 industries under the exclusive purview of the government. Later, this number was further reduced to 3 namely, railways, atomic minerals, and atomic energy.
c. Augmentation of production capacity: Prior to the liberalization policy, industries had to obtain permission from the government in order to expand the scale of production. With the introduction of liberalization policy, the MRTP companies (companies having assets worth more than Rs 100 crore) were free to expand the scale of their business according to the market conditions.
d. Freedom in importing capital goods: Under the policy of liberalization, industrialists were also permitted to import capital goods from foreign countries. As against earlier, where there was a restriction on importing capital goods from other countries, now, there was no such restriction. This implied modernization and improvement in the techniques of production.
e. Reforms in the small-scale industries: In India, small-scale industries are defined on the basis of maximum investment that is allowed in the unit. With the commencement of reforms, the maximum limit has been increased from Rs 5 lakh to Rs 1 crore. This encourages the development and modernization of the industries. Further, the number of products reserved exclusively for the small-scale industries was considerably reduced. That is, an increasing number of manufacturers could now produce the products that were earlier exclusively reserved for the small-scale industries.
Economic Liberalization in India Measures #2
Reforms in the Financial Sector
The financial sector, including the commercial banks, investment banks, and stock exchange operations is controlled by the RBI. RBI controls the commercial banks of the country via various instruments such as Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR), Bank Rate, Prime Lending Rate (PLR), Repo Rate, Reverse Repo Rate, deciding the nature of lending to various sectors, etc.
These are those ratios and rates that are fixed by the RBI. It is mandatory for all commercial banks to follow or maintain these rates as per the direction of the RBI. All these measures control the commercial banks’ operations and also control the money supply in the Indian economy. The following are reforms undertaken in the financial sector.
a. Shift in the role of RBI: With liberalization, the role of RBI has changed from a controller to a mere facilitator of the operations of the financial sector. This implies that the financial sector was free to make its own decisions on various matters without consulting the RBI. This opened up the gates of the financial sector for the private sector.
b. Increasing role of the private sector: The private sector was allowed a greater role in the financial sector. A number of private sector banks (both Indian and foreign) were established. Moreover, the limit for foreign investment was increased to 50%. Banks now enjoyed the freedom to set up new branches without prior permission of the RBI.
c. Foreign institutional investment: Foreign Institutional Investors (FII) such as merchant bankers, mutual funds, pension funds were encouraged to invest in India. It should be noted that despite the reforms, certain functions such as printing of new currency notes, custody of foreign exchange, etc. were still retained with the RBI with the aim of safeguarding the welfare of the nation.
Economic Liberalization in India Measures #3
Fiscal reforms refer to the reforms in the taxation and expenditure policy of the government. Some of the reforms taken in this direction are discussed below.
a. Reduction of indirect tax rates: Attempts have been made to reduce the tax rates for direct taxes (such as income tax and corporation tax). It was realized that high tax rates encourage the evasion of taxes by people. As against this, moderate tax rates encourage saving and investment. In light of this view, as part of the fiscal reforms, the tax rates were lowered.
b. Simplification of tax structure: Prior to the reforms in the year 1991, the structure of tax was very complicated. This scenario consequently resulted in high evasion of tax by the taxpayers. Thus, efforts were made to simplify the tax procedures.
c. Reforms in indirect taxes: Reforms were initiated in indirect taxes with the aim of establishing an integrated national market. In the year 2005, an important breakthrough in the taxation policy of the government was the introduction of VAT. Under VAT, tax is charged on the value-added at each stage of production, instead of paying sales tax on the total value at each stage. This greatly simplified the indirect tax system in the country.
Economic Liberalization in India Measures #4
Trade and Investment Reforms
Many reforms were implemented in the trade as well as the investment sector. The following are some of the important reforms in this sector.
a. Removal of quantitative restriction on trade: Quantitative Restrictions (QRs) refer to the restrictions in the form of limits or quotas on the number of commodities that can either be imported or exported. QRs, usually on imports, refer to non-tariff measures. They are imposed to discourage imports of foreign goods and to reduce Balance of Payment (BOP) deficits. With reforms, such restrictions were removed.
b. Reducing tariff rates: Tariffs are duties imposed on imports. Tariffs make imports from foreign countries relatively expensive than domestic goods, thereby, discouraging imports indirectly. These are imposed to provide a safe and protective environment to the infant domestic firms from their technologically advanced foreign counterparts. As a liberalization measure, tariffs were reduced considerably.
c. Encouragement to Foreign Direct Investment (FDI): Emphasis was laid by the planners to encourage competition in the market and to attract Foreign Direct Investment (FDI) from other countries. Thus, with liberalization in the trade and investment market, the barriers to trade and investment were removed.
d. Opening up of Special Economic Zones (SEZ): SEZ is the specific area that is established to encourage free manufacturing and export activities. In the year 2000-01, during the annual EXIM policy of the government, the setting up of SEZs was announced by the government in order to accelerate the trade process in the country.
Economic Liberalization in India Measures #5
Foreign Exchange Reforms
The foreign exchange reform was the first external sector reform that was initiated in the year 1991. The first step in this direction was the devaluation of the Indian rupee against the foreign currencies. The devaluation of Indian rupees refers to a fall in the value of the rupee against a foreign currency say, a dollar. In other words, after devaluation, a dollar can buy more Indian goods. This had a positive effect in the form of increasing the Indian exports, thereby, increasing the inflow of foreign exchange into the Indian economy. This solved the problem of acute foreign exchange crises in the country.
After the devaluation of the rupee in 1991, the determination of the exchange rate was left to the forces of the market (that is, demand and supply). That is, the foreign exchange system was shifted from a fixed exchange rate system to a floating exchange rate regime. Under the flexible exchange rate, the exchange rate is determined by the demand and supply of the foreign exchange. However, this increased the volatility of the exchange rate by subjecting it to the international market and Indian economic conditions.
Thus, it can be said that under the NEP, India introduced a host of liberalization policy measures. All such measures imparted greater freedom and autonomy in the system. The next important step in the reform policy is the privatization policy. The next lesson deals with the privatization policy in detail.
Economic reforms refer to a set of tools and policies initiated in an economy in order to facilitate the process of growth and development. After going through this lesson, you will understand the Economic Reforms in India