The economic reforms — looking back to look ahead

Context:

The crisis caused by the COVID-19 pandemic has led to a debate about fresh thinking and new approaches to managing the economy and the future of humanity. History matters in the complex economic system. Therefore, it is important to briefly look at the economic reforms of the last 30 years.

Relevance:

GS-III: Indian Economy (Planning, Mobilisation of resources, Growth and development of Indian Economy)

Dimensions of the Article:

1. Situation before 1991 Reforms
2. Economic Reforms of 1991
3. Why were the reforms needed?
4. Approaching IMF & IBRD for Loan
5. What changed and how with the 1991 LPG reforms?
6. Areas that need attention
7. Way Forward

Situation before 1991 Reforms

• The private sector was not allowed to invest in several sectors thought to be critical for development. The so-called “commanding heights” were reserved for the public sector despite its lacklustre performance.
• Where the private sector was allowed, it could invest only after getting an industrial licence, and that was especially hard to get for “large” industrial houses.
• Over 860 items were reserved exclusively for small-scale producers, including many that had very high export potential. Imports were more strictly controlled than in almost any other developing country because it was felt necessary to conserve scarce foreign exchange.
• Consumer goods simply could not be imported so domestic producers faced no import competition. Producers could import capital goods and intermediates needed for production, but this generally required an import licence which was given only if the government was satisfied that the import was essential and domestic substitutes were not available.
• Importantly, the import of technology was controlled and Foreign Direct Investment (FDI) was discouraged.

Economic Reforms of 1991

• 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; foreign exchange reserves, which we generally maintain to import petroleum and other important items, dropped to levels that were not sufficient for even a fortnight.
• The crisis was further compounded by the rising prices of essential goods.
• All these led the government to introduce a new set of policy measures that changed the direction of our developmental strategies.
• In 1991, in response to a major balance-of-payments crisis, India made a radical shift away from its long-standing policy of inward orientation, and the subsequent reforms have moved the policy regime significantly towards market orientation, deregulation, and liberalization.
• Indian industry has responded to the increased competition – domestic as well as foreign – with significant restructuring although the constraints arising from poor infrastructure, largely unreformed public sector, slowly reforming banking sector, inflexible labour laws, and other barriers to exit stand in the way of faster adjustment to the new and emerging policy regime which is inspired by market orientation.

Why were the reforms needed?

• Development policies required that even though the revenues were very low, the government had to overshoot its revenue to meet challenges like unemployment, poverty and population explosion.
• The continued spending on development programmes of the government did not generate additional revenue back then. Moreover, the government was not able to generate sufficiently from internal sources such as taxation.
• When the government was spending a large share of its income on areas that do not provide immediate returns such as the social sector and defence, there was a need to utilise the rest of its revenue in a highly efficient manner.
• The income from public sector undertakings was also not very high to meet the growing expenditure. At times, our foreign exchange, borrowed from other countries and international financial institutions, was spent on meeting consumption needs.
• Neither was an attempt made to reduce such profligate spending nor sufficient attention was given to boost exports to pay for the growing imports.
• In the late 1980s, government expenditure began to exceed its revenue by such large margins that meeting the expenditure through borrowings became unsustainable. Prices of many essential goods rose sharply. Imports grew at a very high rate without matching the growth of exports and foreign exchange reserves declined to a level that was not adequate to finance imports for more than two weeks.
• There was also not sufficient foreign exchange to pay the interest that needed to be paid to international lenders. Also, no country or international funder was willing to lend to India.
• After the Second World War, almost all the newly independent countries adopted the route of planned development. Though they followed an overall model of the indicative planning, many of them had serious inclination towards imperative planning. As in the case of India, the heavy bias towards imperative planning could only be reformed once the process of economic reforms was started in 1991.

Approaching IMF & IBRD for Loan

• India approached the International Bank for Reconstruction and Development (IBRD), popularly known as World Bank and the International Monetary Fund (IMF), and received $7 billion as a loan to manage the crisis.
• For availing the loan, 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 and remove trade restrictions between India and other countries.
• India agreed to the conditionalities of the World Bank and IMF and announced the New Economic Policy (NEP).
• The NEP consisted of wide-ranging economic reforms towards creating a more competitive environment in the economy and removing the barriers to entry and growth of firms.
• This set of policies can broadly be classified into two groups: the stabilisation measures and the structural reform 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, this means that there was a need to maintain sufficient foreign exchange reserves and keep the rising prices under control.
• On the other hand, 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 initiated a variety of policies which fall under three heads viz., liberalisation, privatisation and globalisation.

What changed and how with the 1991 LPG reforms?

Areas that need attention

Human Capital

• The human resource capital (HRC) formation is a good determinant of labour productivity. However, it has been found lacking over the entire period of reforms.
• The lack of quality education, low skilled manpower and inadequacies in basic health care have resulted in low HRC. As per the Global Human Capital Report, 2017, the HRC rank for India stands at 103; Sri Lanka at 70, China at 34, and South Korea at 27.
• In India, labour productivity in manufacturing is less than 10% of the advanced economies including Germany and South Korea, and is about 40% of China, as reflected in a World Bank publication of 2018, The Future of Manufacturing-Led Development. Low productivity has unfavourable consequences for competitiveness, manufacturing growth, exports and economic growth.

Disposable Income

• As indicated in the World Bank database on GDP for 2019, the low per capita GDP in India has direct links to low per capita family income.
• Low wages have a direct bearing on the disposable income of families and leave little room for the majority of households to have enough disposable income to purchase consumer durables or industrial products. This affects the demand.

Research and development

• India’s R&D expenditure is at 0.8% of GDP, vis-à-vis higher value for other fast-emerging economies such as South Korea (4.5%), China (2.1%) and Taiwan (3.3%).
• This is resulting in lower capacity for innovation in technologies and reduced technology readiness, especially for manufacturing.

Labour productivity

• The lack of HRC and low technology readiness have impacted labour productivity adversely. In India, labour productivity in manufacturing is less than 10% of the advanced economies and is about 40% of China, as reflected in a World Bank publication of 2018, The Future of Manufacturing-Led Development.
• Low productivity has unfavourable consequences for competitiveness, manufacturing growth, exports and economic growth.

Capital Expenditure

• Due to a lack of capital expenditure and institutional capacity, and inefficiency in business service processes, there are difficulties in acquiring land for businesses, inefficient utilisation of economic infrastructure, and in providing business services, leading to a long time and more cost in setting up enterprises, resulting in a loss of creative energy of entrepreneurs.

Way Forward

• In order to drive the economy, there needs to be fresh thinking to address the underlying issues comprehensively in an integrated manner.
• The new reforms should be systemic and address structural issues — HRC, skills, research and development (R&D), land management and institutional capacity.
• The focus should be on the quality of business services, technology readiness, labour productivity and per capita income.
• To attract large investment in manufacturing and advanced services, at a basic level, investment in human capital and technology is a prerequisite.
• Industry 4.0 demands enhancing public research and development expenditure to 2% of GDP over the next three years. Consequently, efforts for technology readiness are very essential to stay competitive.
• There is a need to work on strategies to enhance per capita income by more wages for workers through higher skills and enhancing minimum wages, besides improving the social security net.
• Increased cost of labour can be compensated by higher productivity, some tax benefits in the initial period of wage reforms especially for Micro, Small and Medium Enterprises, besides reducing transaction costs in business and improving infrastructure utilisation efficiency.
• It is necessary to build the capacity of public institutions to create a good environment for business and industry. The process of reforms is equally important.
• The future of the economy should be particularly viewed in the backdrop of a significant and irreversible shift in terms of reliance on global supply.
• Strategies adopted since the 1990s till now may not ensure adequate returns, and call for innovative approaches in public policymaking.
• What is needed is a systemic approach encompassing inter-connected basic factors of the economic system for policy reforms for setting the economic fundamentals right, in order to unlock creativity and innovation in the economic system, raise the total factor productivity (TFP), or a measure of productive efficiency, and to achieve higher growth.

-Source: The Hindu