6. Economics Notes 04

Elaborate Notes

Economic History Post-1990s: The Crisis and Reforms

The period leading up to 1991 was marked by a severe macroeconomic crisis, the culmination of structural weaknesses that had developed over decades.

• Inefficiency of Public Sector Undertakings (PSUs): Post-independence, India adopted a mixed economy model with a significant role for the state, as envisioned in the Industrial Policy Resolutions (e.g., 1948, 1956). PSUs were established to command the “heights of the economy.” However, by the 1980s, many had become inefficient, loss-making entities plagued by overstaffing, bureaucratic control, and a lack of competitive pressure. This resulted in a poor return on capital and a significant drain on government revenues, as noted by economists like Bimal Jalan in his work The Indian Economy: Problems and Prospects (1992).
• Persistent High Inflation: The oil shocks of 1973 and 1979, orchestrated by the Organization of the Petroleum Exporting Countries (OPEC), led to a surge in global oil prices. As a net importer of oil, India’s import bill skyrocketed, fueling cost-push inflation. This, combined with monetized deficits (RBI printing money to finance government borrowing), kept inflation persistently high, eroding real incomes.
• Stagnation in the Banking Sector: Following the nationalization of 14 major commercial banks in 1969 and another 6 in 1980, the banking sector expanded its reach but suffered from declining efficiency. Directed lending, administered interest rates, and high Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) requirements limited their profitability and flexibility. The Narasimham Committee Report (1991) later highlighted these issues, pointing to political interference and a lack of prudential norms.
• High Trade and Fiscal Deficits:
  • Trade Deficit: India consistently imported more than it exported. The primary imports were essential commodities like food grains (until the Green Revolution stabilized production), fuel (crude oil), and fertilizers. The inward-looking policy of Import Substitution Industrialization (ISI) failed to create a globally competitive export sector, leading to a chronic trade deficit.
  • Fiscal Deficit: The government’s expenditure consistently outstripped its revenue. High spending on subsidies (food, fertilizer), defense, and interest payments, coupled with a narrow tax base and PSU losses, forced the government to borrow heavily. The fiscal deficit, which represents the total borrowing requirement of the government, grew to alarming levels, reaching over 8% of GDP by 1990-91.
• Depletion of Foreign Exchange (FOREX) Reserves: The culmination of these issues was a severe Balance of Payments (BoP) crisis. The Gulf War of 1990-91 exacerbated the situation by increasing oil prices and cutting off remittances from Indian workers in the Middle East. By mid-1991, India’s FOREX reserves had dwindled to just over $1 billion, barely enough to cover 15 days of imports. This crisis forced India to physically airlift its gold reserves to the Bank of England and Union Bank of Switzerland as collateral for an emergency loan, a fact documented in the memoirs of officials like Y.V. Reddy.
• Reasons for Delayed Reforms: Despite the visible decline in macroeconomic indicators since the 1970s, structural reforms were repeatedly postponed due to:
  1. Politicisation of Planning: The planning process often became an arena for political bargaining rather than rational economic decision-making.
  2. Political Instability: The Emergency (1975-77) and subsequent periods of unstable coalition governments in the late 1970s and 1980s lacked the political will to undertake difficult reforms.
  3. External Shocks: The wars with China (1962) and Pakistan (1965, 1971) diverted resources towards defense. The oil crises of the 1970s forced a focus on short-term crisis management rather than long-term structural change.
  4. Disintegration of the USSR (1991): The collapse of the Soviet Union, India’s major trading partner under the Rupee-Rouble trade agreement, was a significant shock, disrupting a large and stable export market.

The IMF Intervention and New Economic Policy (LPG)

Facing imminent default, India approached the International Monetary Fund (IMF) and the World Bank for a bailout loan.

• IMF Conditionality: The IMF provides financial assistance to member countries facing BoP crises, but these loans are conditional upon the implementation of Structural Adjustment Programs (SAPs). These conditions, heavily influenced by the “Washington Consensus” ideology prevalent at the time, required India to open its economy. This was a reaction against what was seen as the failure of state-led development models. The BRICS nations later established a Contingent Reserve Arrangement (CRA) as an alternative to the IMF, aiming to provide financial support without the stringent policy conditionalities.
• LPG Reforms (1991): Under the leadership of Prime Minister P.V. Narasimha Rao and Finance Minister Dr. Manmohan Singh, India initiated a comprehensive set of reforms.
  • Liberalisation: This involved systematically dismantling the “Licence-Permit-Quota Raj.” Industrial licensing was abolished for most industries, restrictions on private sector entry were removed, and the financial sector was deregulated. The goal was to move from a command-and-control system to a market-based one.
  • Privatisation: This meant reducing the role of the public sector and expanding the scope for the private sector. This was done through disinvestment (selling government equity in PSUs) and allowing private entry into sectors previously reserved for the government (e.g., telecom, aviation, power).
  • Globalisation: This involved integrating the Indian economy with the global economy. This was achieved by reducing tariffs and non-tariff barriers on imports and exports, liberalizing the regime for foreign investment (both direct and portfolio), and making the rupee convertible on the current account. The focus shifted from self-sufficiency (Import Substitution) to leveraging global markets (Interdependence and Export Promotion).
• The Primacy of Efficiency: In a globalized market, survival and growth depend on efficiency. This includes productive efficiency in manufacturing, efficiency in labour and capital allocation, and efficiency in the delivery of services, including after-sales support and robust supply chains.

Key Economic and Financial Concepts

• FOREX Reserve Components: The RBI acts as the custodian of India’s foreign exchange reserves, which consist of four main components:
  1. Foreign Currency Assets (FCA): Holdings of currencies like the US Dollar, Euro, Pound Sterling, and Japanese Yen, held in the form of foreign government securities and deposits with foreign central banks.
  2. Gold: Held as a store of value and a “hard currency” that is universally accepted. High gold demand in India is driven by cultural traditions (weddings, festivals), its use as a store for unaccounted wealth (‘black money’), a hedge against inflation, and historically low penetration of formal financial instruments.
  3. Special Drawing Rights (SDRs): An international reserve asset created by the IMF, whose value is based on a basket of five major currencies. It represents a potential claim on the freely usable currencies of IMF members.
  4. Reserve Tranche Position (RTP): The portion of a member country’s quota with the IMF that can be drawn upon without conditions.
• Hedging: A strategy to mitigate financial risk. In the context of inflation, holding cash is risky as its purchasing power erodes. Investing in assets like gold, which tend to retain or increase their value during inflationary periods, is a form of hedging.
• Supply Chain Management: This encompasses the entire process from sourcing raw materials to delivering the final product to the consumer. It involves logistics, inventory management, packaging, and transportation.
  • Backward Integration: A firm moving closer to its suppliers in the supply chain. For the Food Corporation of India (FCI), backward integration means procuring grains directly from farmers. For a textile mill, it could mean owning cotton farms.
  • Forward Integration: A firm moving closer to the final consumer. For Amul, which procures milk from cooperative societies (backward integration), setting up its own ice cream parlours for direct sale is forward integration.

The Post-LPG Era (1991-2004): A Structural Shift

The reforms of 1991 fundamentally altered the structure and trajectory of the Indian economy.

Parameter	Pre-1991 Scenario	Post-1991 Scenario
GDP Contribution	Agriculture was the largest contributor.	The Tertiary (Services) sector became the dominant contributor.
Job Creation	The public sector was the primary engine of formal employment.	The private sector emerged as the main creator of jobs.
Economic Openness	A largely closed economy with high tariffs and investment restrictions.	An open economy integrated with global trade and capital flows.
Policy Paradigm	Import Substitution Industrialization (ISI).	Interdependence and export-led growth.
Economic Ideology	Socialist-leaning mixed economy with state dominance.	Market-led economy driven by demand and supply forces.
Growth Rate	Averaged around 3.5%, termed the “Hindu Rate of Growth” by economist Raj Krishna in 1978.	Consistently grew above 6-8%, breaking free from the low-growth trap.
Primary Challenge	Achieving basic economic growth.	Achieving Inclusive Growth; tackling rising inequality.
Poverty	High incidence of absolute poverty.	Significant reduction in poverty, though the pace was slower than in East Asian countries like China.
Labour Force	A vast majority dependent on agriculture.	Still a large proportion (around 42.4% as of recent estimates) dependent on agriculture, indicating a structural problem.
Foreign Investment	Highly restricted and regulated under the Foreign Exchange Regulation Act (FERA), 1973.	Exponential increase in Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI), regulated by the more liberal Foreign Exchange Management Act (FEMA), 1999.
Illicit Finance	Handling black money was relatively easier due to a closed system.	Handling black money became more complex due to integration with the global financial system, use of tax havens, and sophisticated money laundering techniques.

• Over-Tertiarization and Jobless Growth: India’s unique development path saw it leapfrog from a primarily agrarian economy to a service-dominated one, bypassing a robust manufacturing phase. This is termed over-tertiarization. While the services sector (especially IT and ITeS) propelled GDP growth, it did not create enough jobs for the country’s large, low-skilled workforce. This phenomenon is known as jobless growth. The failure to develop labour-intensive manufacturing sectors (like textiles, apparel, leather) meant that surplus labour from agriculture could not be absorbed, leading to disguised unemployment (where marginal productivity of labour is near zero) in the rural sector.

Market Mechanisms and Consumer Behaviour

• Law of Diminishing Marginal Utility: This fundamental economic principle states that as a consumer consumes successive units of a commodity, the additional satisfaction (marginal utility) derived from each extra unit decreases. Because the utility decreases, the consumer is willing to pay a lower price for each additional unit. This explains why the individual demand curve is downward-sloping (an inverse relationship between price and quantity demanded).
• Shifts in the Demand Curve: A change in price causes a movement along the demand curve. However, factors other than price (like income, tastes, price of related goods) cause the entire curve to shift. An increase in consumer income, for instance, leads to a rightward shift in the demand curve, indicating that at any given price, consumers are willing and able to buy more. This is considered a favourable shift in demand.
• Exceptions to the Law of Demand:
  • Inferior Goods: Goods for which demand decreases as consumer income rises. Consumers switch to better-quality substitutes. For example, as income increases, a household might shift from consuming coarse grains (like millet) to finer grains (like basmati rice).
  • Veblen Goods: Luxury or status goods (e.g., Rolls-Royce cars, designer watches) for which demand increases as the price increases. The high price itself is a marker of status and exclusivity, making the good more desirable. These were studied by economist Thorstein Veblen.

The Balance of Payments (BoP)

• Definition: The BoP is a systematic accounting record of all economic transactions between the residents of a country and the rest of the world during a specific period (typically a financial year).
• Structure: It has two main accounts:
  1. Current Account: Records transactions in goods (visible trade), services (invisible trade), income (profits, dividends), and unilateral transfers (remittances, grants). These are transactions that do not create future claims.
  2. Capital Account: Records transactions involving the purchase and sale of assets, such as foreign direct investment (FDI), foreign portfolio investment (FPI), loans, and banking capital. These transactions create future claims.
• Balance of Trade (BoT): This is a sub-component of the Current Account and measures the difference between the value of a country’s merchandise exports and imports.
  • BoT = Value of Exports - Value of Imports
  • A BoT Deficit (Imports > Exports) implies an outflow of domestic currency to pay for foreign goods.
• BoP Crisis and Currency Depreciation: During the 1990-91 crisis, India’s BoT deficit widened dramatically due to high oil import bills. This meant India needed more US dollars to pay for its imports. In the foreign exchange market, the high demand for dollars relative to its supply caused the value of the Indian Rupee to fall, a process known as depreciation. An increasing trade deficit puts downward pressure on the domestic currency.

---

Prelims Pointers

• Bank Nationalisation: 14 major commercial banks were nationalised in 1969; 6 more were nationalised in 1980.
• Fiscal Deficit: Represents the total borrowing requirements of the government in a financial year.
• FOREX Reserves Components: 1. Foreign Currency Assets (FCA), 2. Gold, 3. Special Drawing Rights (SDRs), 4. Reserve Tranche Position (RTP).
• Custodian of FOREX: The Reserve Bank of India (RBI).
• Hedging: A strategy used to minimize or avoid risk, often against inflation or currency fluctuations.
• Grants: Unilateral (one-way) transfers that do not need to be repaid.
• Backward Integration: A company moving towards its source of raw materials/suppliers in the supply chain.
• Forward Integration: A company moving closer to the end consumer in the supply chain.
• Hindu Rate of Growth: A term coined by economist Raj Krishna to describe the slow average growth rate of the Indian economy (around 3.5%) before 1991.
• Over-Tertiarization: The phenomenon of the service sector’s contribution to GDP growing disproportionately large compared to the manufacturing sector.
• Disguised Unemployment: A situation where more people are employed in a job than are actually required. The marginal productivity of the extra labour is zero or near-zero. It is most common in the agricultural sector.
• FERA (1973): Foreign Exchange Regulation Act. It treated violations as criminal offences.
• FEMA (1999): Foreign Exchange Management Act. It replaced FERA and treats violations as civil offences, reflecting a more liberal approach.
• Tax Havens: Countries or jurisdictions with very low tax rates and high financial secrecy (e.g., Cayman Islands, Mauritius, Cyprus).
• Law of Diminishing Marginal Utility: Explains the downward-sloping nature of the demand curve.
• Veblen Goods: Luxury goods that defy the law of demand; demand increases as price increases.
• Inferior Goods: Goods for which demand falls as consumer income rises.
• Balance of Payments (BoP): A record of all economic transactions of a country with the rest of the world.
• Balance of Trade (BoT): Part of the BoP’s Current Account; records the difference between merchandise exports and imports only.
• Currency Depreciation: A fall in the value of a currency in a floating exchange rate system due to market forces of demand and supply.

---

Mains Insights

• Cause and Effect: From State Control to Market Reforms

  • Cause: The pre-1991 inward-looking, state-dominated economic model (License Raj, PSU dominance, import substitution) led to inefficiency, low growth, and a lack of competitiveness. This culminated in the 1991 BoP crisis.
  • Effect: The crisis acted as a catalyst for the LPG reforms, which shifted the economic paradigm towards a market-led, open economy. This resulted in a higher growth trajectory but also created new challenges like rising inequality and jobless growth. The reforms represent a clear cause-and-effect chain in India’s modern economic history.

• Historiographical Debate: “Reforms by Stealth” vs. “Reforms by Conviction”

  • One viewpoint, often associated with scholars like Jagdish Bhagwati, argues that the 1991 reforms were a pragmatic response born out of a severe crisis (‘reforms by compulsion’).
  • Another perspective suggests that an internal consensus for reforms had been building since the 1980s, but political instability prevented their implementation. The 1991 crisis merely provided the political window of opportunity to push through these ‘reforms by conviction’. Understanding this debate is crucial for analyzing the political economy of reforms in India.

• The Paradox of Over-Tertiarization and Jobless Growth

  • Analysis: India’s leapfrogging from agriculture to services, bypassing manufacturing, is an anomaly in the standard economic development path. While the services sector boosted GDP and created a new middle class, its job-creation capacity is limited to skilled and semi-skilled labour.
  • Implication: This leaves a vast pool of unskilled and low-skilled labour trapped in low-productivity agriculture, leading to disguised unemployment and rural distress. This structural imbalance is a major obstacle to inclusive growth and poses a significant socio-economic challenge. For inclusive growth, India must focus on reviving labour-intensive manufacturing (e.g., ‘Make in India’) and boosting the rural non-farm economy.

• Growth vs. Inclusive Growth: A Central Policy Dilemma

  • The post-1991 era successfully broke the ‘Hindu Rate of Growth’ and lifted millions out of poverty. However, the market-led model also exacerbated income and wealth inequalities (as highlighted by the Oxfam reports and economists like Thomas Piketty).
  • This has fueled a major policy debate, contrasting the ‘growth-centric’ approach (advocated by Bhagwati and Panagariya, who argue that growth is the best anti-poverty tool) with the ‘human development’ approach (advocated by Amartya Sen and Jean Drèze, who emphasize direct state intervention in health, education, and social security). A balanced approach, using the fruits of high growth to fund robust social infrastructure, is essential for sustainable and equitable development (GS Paper II & III).

• Financial Inclusion as a Prerequisite for Inclusive Growth

  • The summary highlights that the need for inclusive growth arises from the inequalities spawned by LPG reforms. Financial inclusion is a critical tool to achieve this.
  • By bringing the unbanked population into the formal financial system, financial inclusion:
    1. Reduces Leakages: Enables direct benefit transfers (DBT), ensuring welfare reaches the intended beneficiaries.
    2. Curb Exploitation: Reduces dependence on informal moneylenders who charge exorbitant interest rates.
    3. Promotes Savings & Investment: Encourages a culture of savings and provides access to credit for productive purposes, thereby enhancing economic growth from the grassroots level. This linkage is crucial for GS Paper III answers on inclusive growth.

• Shifting Policy from Regulation to Management: FERA to FEMA

  • The transition from FERA (criminal offense) to FEMA (civil offense) is not merely a legal change; it represents a fundamental ideological shift.
  • FERA reflected a mindset of suspicion towards foreign capital, viewing it as something to be strictly controlled (‘Regulation’). FEMA reflects a mindset of partnership, viewing foreign capital as a resource to be attracted and managed for economic growth (‘Management’). This change was pivotal in boosting investor confidence and integrating India into the global economy.