Economic Reforms in India

What does the word ‘reform’ mean? The dictionary meaning of the word ‘reform’ is to make changes in something so as to improve it. In this sense, economic reforms can be defined as changes in the economic policies so as to improve the economic condition. In other words, 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


Need for Economic Reforms in India


In the initial years of planning, India followed the lines of a socialist economy. The public sector was accorded a dominant role in the growth and development process. This was done in order to achieve the twin objective of the development of the heavy and capital industries essential for the growth process along with the welfare of the masses. As against this, the private sector played only a subsidiary role.

The private sector was subject to various restrictions such as licensing, and the permission to produce only a few goods and services. On the international front, we followed an inward-looking trade policy, that is, the policy of import substitution. Imports of the goods that could be produced domestically were discouraged.

The domestic industries were under a safety net, where they were protected from foreign competition through barriers such as tariffs and quotas. The rationale behind such a move was to protect the infant industries from foreign competition as well as to save the scarce foreign exchange that was lost in the imports of unnecessary items.

Such a policy yielded fruitful results in the short run, but in the long run, it had serious negative consequences. The public sector was plagued with inefficiencies and incurred huge losses. Moreover, excessive control on the private sector hampered their growth and the industrial sector lacked modernization.

As a result, the Indian economy regressed into a state of stagnation. By the year 1991, India found itself in a serious economic crisis. The public expenditure continued to rise and far exceeded the revenue receipts. As a result, the government had to increasingly resort to borrowings from foreign countries. Moreover, due to the rising imports, the foreign exchange reserves of India continued to fall. The foreign exchange reserves fell to such a low level that they were not enough to pay even for the imports of ten days. As a result, the international market lost faith in the Indian economy. No new loans and grants were available to India from foreign countries.

To move out of the situation, India approached the International Bank for Reconstruction and Development (IBRD) and International Monetary Fund (IMF) for financial support. These institutions provided help in the form of loans but on the condition that the Indian economy would liberalize. That is, the international institutions insisted India remove restrictions on the private sector and open up the economy to the world economy by removing trade restrictions. Thus, the initiation of reforms became inevitable.


Why were Economic reforms introduced in India?


The following are the factors that necessitated the need for economic reforms in India.


Reasons for Economic Reforms in India #1


Huge fiscal deficit: Throughout the 1980s, fiscal deficit (fiscal deficit reflects the total borrowings and other liability requirements of the government) was getting worse due to huge non-development expenditures. As a result, the gross fiscal deficit rose from 5.7% of GDP to 6.6% of GDP during 1980-81 to 1990-91. Subsequently, a major portion of this deficit was financed by borrowings both from an external and domestic source.

The increased borrowings resulted in increased public debt and mounting interest payment obligations. The domestic borrowings by the government increased from 35% to 49.8% of GDP during 1980-81 to 1990-91. Moreover, the interest payments obligations accounted for 39.1% of the total fiscal deficit. Consequently, India lost its financial worthiness in the international market and, fell into a debt trap. Thus, economic reforms were needed urgently.


Reasons for Economic Reforms in India #2


Weak BOP situation: Balance of Payment (BOP) represents the record of inflow of foreign exchange into the country and the outflow of foreign exchange from the country Due to the lack of competitiveness of Indian products, India was not able to earn enough foreign exchange through exports. As against this, the imports continued to rise. As a result, the foreign exchange earnings fell short of the payment obligations.

The current account deficit (representing the excess of export payments over import earnings) rose from 1.35% to 3.69% of GDP during 1980-81 to 1990-91. In order to finance this huge current account deficit, the Indian Government borrowed a huge amount from the international market. Consequently, the external debt increased from 12% to 23% of GDP during the same period. On the contrary, Indian exports were not potent enough to earn sufficient foreign exchange to repay these external debt obligations. This BOP crisis compelled the need for economic reforms.


Reasons for Economic Reforms in India #3


High level of inflation: The high fiscal deficits forced the Central government to monetize (i.e. finance) the deficit. The government resort to borrowings from RBI in the form of deficit financing (that is, the printing of new currency notes). This deficit financing increased the level of money supply, which resulted in a rise in the inflation rate. The rate of inflation rose from 6.7% per annum to 10.3% per annum during the 1980s to 1990.

However, a rise in the inflation rate made the domestic goods more expensive that hampered our exports.


Reasons for Economic Reforms in India #4


Sick PSUs: Public Sector Undertakings (PSUs) were assigned the prime role of industrialization and removal of income inequality and poverty. But the subsequent years witnessed the failure of PSUs to perform these roles efficiently and effectively. Instead of being a revenue generator for the Central government, these became a liability. The sick PSUs added an extra financial burden on the government’s budget.


Reasons for Economic Reforms in India #5


Fall in the foreign exchange reserves: Foreign exchange reserves of India fell to a very low level. The foreign exchange reserves fell to such a low level that they were not enough to pay for the imports of even two weeks. The situation became much worse than India had to mortgage its gold reserves with the World Bank to repay the mounting debts. In such a situation, India had to follow the path of liberalization as suggested by the World Bank and IMF.

In light of the above factors, India initiated multi-dimensional economic reforms in the year 1991, which are collectively known as New Economic Policy (NEP). The New Economic Policy replaces liberalization (L) in place of licensing, privatization (P) in place of quotas, and globalization (G) in place of permits for exports and imports. In the subsequent lessons, we will discuss this policy in greater detail.


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