Background to 1991 Reforms & Liberalisation

3.1 Introduction — Why India Needed New Policies

For four decades after independence, India ran a mixed economy that blended capitalist and socialist features. Over time, this framework produced thick rules and licences aimed at controlling industry and trade. Some scholars argue these controls hampered growth; others point to genuine achievements — diversified industry, food security and stronger savings. Yet by the late 1980s, the mixed model was visibly straining. In 1991, India faced a serious crisis on its external account, and the government rolled out a sweeping new package of reforms — the New Economic Policy^?, popularly known as LPG^? — Liberalisation, Privatisation and Globalisation.

3.2 Background to the 1991 Crisis

The roots of the 1991 financial crisis can be traced to the inefficient management of the Indian economy in the 1980s. To run programmes and pay for general administration, the government raises money from taxation, profits of public sector enterprises and other sources. When spending exceeds income, it borrows from banks, citizens and international agencies — creating a fiscal deficit^?. To buy imports such as petroleum, India must pay in dollars, which it earns from exports.

3.2.1 What Went Wrong in the 1980s

Several pressures pushed the system off balance:

By the late 1980s, government expenditure exceeded revenue by such large margins that financing the gap through borrowing became unsustainable. Foreign exchange reserves dwindled to a level inadequate to fund imports for more than two weeks, and the country could not even meet interest payments due to international lenders. Worse still, no country or international funder was willing to lend India fresh money.

3.2.2 The IMF–World Bank Loan Conditions

India turned to the International Bank for Reconstruction and Development (IBRD) — popularly the World Bank — and the International Monetary Fund (IMF). India received USD 7 billion as a loan to manage the crisis. In return, these international agencies expected India to:

• Liberalise and open up the economy by removing restrictions on the private sector;
• Reduce the role of the government in many areas;
• Remove trade barriers between India and other countries.

India agreed to these conditionalities and announced the New Economic Policy (NEP). The NEP was a wide-ranging reform package whose thrust was to create a more competitive environment and remove barriers to entry and growth of firms. The policies fall into two layers:

3.3 Liberalisation — Untying the Indian Economy

Until 1991, the regulating hand of the state reached into almost every business decision. Liberalisation^? was launched to end these restrictions and open various sectors to competition. Some liberalisation steps were tried in the 1980s in industrial licensing, export–import policy, technology upgradation, fiscal policy and foreign investment, but the post-1991 reforms were far more comprehensive. Five areas drew the heaviest action: industry, finance, taxes, foreign exchange, and trade & investment.

3.3.1 Deregulation of the Industrial Sector

Before reforms, regulatory mechanisms operated in four ways: (i) industrial licensing^? required every entrepreneur to seek government permission to start a firm, close a firm or decide output volumes; (ii) the private sector was barred from many industries; (iii) some goods could only be made by small-scale industries; and (iv) prices and distribution of selected industrial products were directly controlled.

3.3.2 Financial Sector Reforms

The financial sector — commercial banks, investment banks, stock exchanges and the foreign exchange market — is regulated by the Reserve Bank of India (RBI). Pre-1991, the RBI was a hard regulator: it controlled how much money banks could keep, set interest rates, and directed lending. A central aim of reform was to shift the RBI from regulator to facilitator, letting banks decide more matters on their own.

3.3.3 Tax Reforms

Tax reforms cover changes in the government's taxation and public expenditure policies — together called fiscal policy. Taxes are of two kinds: direct (on personal incomes and corporate profits) and indirect (on goods and services).

• Direct taxes lowered: Since 1991, taxes on individual incomes have been continuously reduced. High rates were a major reason for tax evasion; moderate rates encourage savings and voluntary disclosure. The corporation tax rate, which was very high earlier, has also been gradually cut.
• GST introduced (2016): The Constitution was amended in 2016 to empower both state and union governments to levy Goods and Services Tax. GST is expected to add government revenue, reduce tax evasion, and create "one nation, one tax and one market".
• Simplification: Procedures have been simplified and rates lowered to encourage better compliance.

3.3.4 Foreign Exchange Reforms — The Devaluation Move

The first major reform in the external sector touched the foreign exchange market. In 1991, as an immediate measure to ease the BoP crisis, the rupee was devalued^? against foreign currencies. This single step had two effects: it raised the inflow of foreign exchange (Indian exports became cheaper to foreigners), and it set the stage to free the rupee from direct government control. Today, markets determine exchange rates, based on the demand and supply of foreign exchange — although the RBI may intervene occasionally.

3.3.5 Trade and Investment Policy Reforms

The pre-1991 trade regime relied on tight import controls and very high tariffs meant to protect domestic industry. NCERT notes that this protection actually reduced efficiency and competitiveness and slowed manufacturing growth. The trade reforms aimed at three things: