ICAI Notes 7.1 - Economic Reforms | Business Economics for CA Foundation PDF Download

Learning Objectives

• Know the background behind economic reforms in India.
• Know the sectors in which economic reforms were carried out.
• Understand the reforms in the industrial sector, financial, external and fiscal sectors.
• Understand how reforms have fared since their introduction in India.

Background

After Independence, India followed the policy of planned growth and for this it pursued conservative policies. The public sector was given a dominant position and was made the main instrument of growth. The fiscal policy was framed in a way that it mobilized resources from the private sector to finance development programs and public investment in infrastructure. Similarly, the monetary policy sought to regulate financial flows in accordance with the needs of the industrial sector and to keep inflation under control. Foreign trade policy was formulated to protect domestic industry and keep trade balance at manageable limits. These conservative policies continued for decades, but it was noticed as early as in the 1980s that there was:

• excess of consumption and expenditure over revenue resulting in heavy government borrowings; 
• growing inefficiency in the use of resources; 
• over protection to industry; 
• mismanagement of firms and the economy; 
• mounting losses of public sector enterprises; 
• various distortions like poor technological development and shortage of foreign exchange; and imprudent borrowings from abroad and mismanagement of foreign exchange reserves.

Realizing these drawbacks, economic reforms were set in motion though on a modest scale in 1985. However, measures undertaken were ad-hoc, half-hearted and non serious. As a result, sign of crisis began to manifest themselves in 1991. These were:

1. Low foreign exchange reserves: The available foreign exchange reserves were just sufficient to finance imports of three weeks.
2. Burden of National Debt: National Debt constituted 60 percent of the GNP in 1991. The large fiscal deficits in the previous five years meant that the government was borrowing increasingly to meet the shortfall of the revenue account.
3. Inflation: Gulf war, hike in the administrative prices of many essential items and excess liquidity in the economy led to very high rate of inflation in the country. The wholesale prices increased at an annual average rate of 12 percent during the year.

The government responded to the crisis by introducing economic reforms in the country. Reforms were introduced in all major sectors of the economy namely:

• Industrial sector
• Financial sector
• External sector
• Fiscal policy

Industrial Sector 

In the industrial sector, following reforms were undertaken: 

• Industrial licensing was abolished for all projects except for 18 industries related to strategic and security concerns, social reasons, hazardous chemicals and over-riding environmental reasons and items of elitist consumption. At present there are only 6 industries which relate to health, strategic and security considerations remain under the purview of industrial licensing.
  These are:
  1. Distillation and brewing of alcoholic drinks.
  2. Cigars and Cigarettes of tobacco and manufactured tobacco substitutes.
  3. Electronic Aerospace and Defence equipment: all types.
  4. Industrial explosives including detonating fuses, safely fuses, gun powder,                   nitrocellulose and matches.
  5. Hazardous chemicals.
  6. Drugs and Pharmaceuticals (according to modified Drug Policy issued in                      September 1994 as amended in 1999). 
• Only 8 industries groups where security and strategic concerns pre-dominate would be reserved exclusively for the public sector. At present, there are only 3 industries which are reserved for the public sector. They are
  (i) atomic energy,
  (ii) the substances specified in the schedule to the notification of the Government of India in the Department of Atomic Energy, and
  (iii) rail transport. In 2001, defense production was deserved and opened up to private participation through licensing. A minimum capital of Rs.100 crore would be required by the companies seeking entry into defense production. Foreign investment of up to 26% is being allowed. 
• In projects where imported capital goods are required automatic clearance would be given in the following cases:
  (a) where foreign exchange availability is ensured through foreign equity. [It is no longer necessary for automatic approval by the RBI that the amount of foreign equity should cover the foreign exchange requirements for import of capital goods needed for the project.]
  (b) If the value of imported capital goods required is less than 25% of the total value of plant and machinery up to a maximum of Rs. 2 crore.
• In locations other than cities of more than 1 million population, there would be no requirement of obtaining industrial approvals from the Central Government except for industries subject to compulsory licensing. 
• Industries other than those of non-polluting nature such as electronics, computers, software, and printing would be located outside 25 km. of periphery except in prior designated industrial areas. 
• The mandatory convertibility clause would no longer be applicable for term loans, from the financial institutions for new projects. 
• The system of phased manufacturing programmes approved on a case by case basis would not be applicable to new projects.
• Existing units would be provided a new broad banding facility to enable them to produce any article without any investment. 
• The exemption from licensing would apply to all subsequent expansion of existing units. 
• All existing schemes (the licenses registration, exempted registration, DGTD registration) would be abolished. Entrepreneurs would henceforth only be required to file an information memorandum on new projects and subsequent expansions.

Foreign Investment 

• As a consequence, a list of high-priority industries (totaling 34) was prepared wherein automatic approval would be available for direct foreign investment up to 51 percent foreign equity. 
• In 1999, the Government decided to place all items under the automatic route for Foreign Direct Investment/NRI/OCB investment except for a small negative list. During the years 2000–03, 100 percent FDI was allowed in Drugs and pharmaceuticals, hotels and tourism, courier services, oil refining, mass rapid transport system, airports, business to business E-commerce, special economic zones industries, and certain telecom industries. 
• Similarly, 100 percent FDI was also allowed in internet services providers, net providing gateways (both for satellite and submarine cables) infrastructure providing dark fiber (IP category I), electronic mail and voice mail, advertising film sector, tea (subject to certain conditions) and for development of township (however with prior approval). 49% FDI was allowed in banking. 
• Apart from this, 26% of FDI has been allowed in defense production insurance and print media. (This is of course, subject to certain conditions).
• During 2004-05, foreign investment in the banking sector was further liberalized by raising the FDI limit in private sector banks to 74 percent under the automatic route. Similarly, there was an increase in the FDI limits in ‘Air Transport Services’ up to 49 percent through automatic route. Also, the FDI ceiling in the telecom sector in certain services was increased from 49 percent to 74 percent in 2005.
•  Besides the above, guidelines on equity cap on FDI have been revised, and FDI up to 100 percent is now permitted in many products such as distillation and brewing up of potable alcohol, manufacture of industrial explosives, manufacture of hazardous chemicals, laying of natural gas lines / LNG lines, etc.
• FDI is prohibited in certain sectors as retail trading (except single brand product retailing), atomic energy, lottery business, gambling and betting, business of chit fund, Nidhi companies, trading in transferable development rights and activities/sectors not opened to private sector investment. Except these sectors, FDI is allowed in all the sectors of the economy at varying specified degrees either through government approval route or the automatic route of the RBI.

MRTP Act

• In the pre-reform period, companies with more than defined investment in assets were required to take prior approval of central government for establishment of new undertakings, expansion of existing undertakings, merger, amalgamation and take over and appointment of directors (under certain circumstances). 
• Under the new Industrial Policy of 1991, this requirement was abolished. Thus, with this action, the constraints imposed on growth and restructuring of large business houses were removed.

Financial Sector

Financial sector reforms mainly relate to three categories as (a) banking sector reforms (b) capital reforms (c) Insurance sector reforms. Here, we will discuss banking sector reforms only.

Banking Sector Reforms

• In the pre-reform period the banking system functioned in a highly regulated environment characterised by:
• Administered interest rate structure. 
• Quantitative restrictions on credit flows. 
• High reserves requirements under Cash Reserve Ratio (CRR). 
• Keeping significant proportion of lendable resources for the priority sectors under Statutory Liquidity Ratio (SLR). 

These restrictions resulted in inefficiency of the banks which in turn led to low or negative profits. As a result, measures were taken to reform banks. The important ones are: 

• CRR was gradually lowered from its peak at 15 per cent during pre-reforms year to 4.5 per cent in June 2003 but raised to 5 per cent in 2004 further to 7.5 per cent (in stages) in 2007. In January 2009, CRR was again reduced to 5 per cent. 
• SLR was reduced from its peak of 38.5% during 1990-1992 to 24 per cent in November 2008.
• Prime lending rates of banks for commercial credit are now entirely within the purview of the banks and not set by the RBI. The rate of saving accounts and rates of interest on export credit are still subject to regulations. With effect from April 2001, PLR has been converted into a benchmark rate for banks rather than treating it as the minimum rate.
• Bank Rate has been reduced from 8 per cent to 6 per cent effective from April, 2003. 
• Rate of interest on saving deposits of commercial banks was reduced from 4.5% in 1980’s to 3.5% in recent years. 
• In 1993, RBI issued guidelines for licensing of new banks in the private sector. 
• Fresh guidelines for licensing new banks were issued in January, 2000. These guidelines mainly provided for raising initial minimum capital, increasing the contribution of promoters and keeping the NRI participation in the primary equity of a new bank to the maximum extent of 40 per cent. 
• Public sector banks have been encouraged to approach the public to raise resources. 
• Recovery of debts due to banks and other financial institutions Act, 1993 was passed and special recovery Tribunals were set up to facilitate quicker recovery of loans arrears. 
• For achieving the objective of reducing non-performing assets (NPAs) banks have been advised to tone up their credit risk management system. 
• The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act was passed for assisting banks in the recovery of their loans.
• A credit information bureau would be established to identify bad risks. 
• Derivative products such as forward rate agreement (FRAs) and interest rate swaps have been introduced. 
• The RBI has emphasised transparency, diversification of ownership and strong corporate governance practices to mitigate the fear of systemic risks in the banking sector. 
• A roadmap for entry of foreign banks consistent with World Trade Organisation (WTO) has also been released by the RBI. 
• The Basel II framework, has been operationalised by banks since March, 2008. 
• The RBI has also issued detailed guidelines for the merger/amalgamation in respect of the private sector banks in 2005. 
• Other measures include removing/relaxing credit restrictions for purchase of consumer durable, enlarging the coverage of priority sector to include software, agro-processing industries and venture capital.

The financial crisis that surfaced around August 2007 affected economies world wide. India could not insulate itself from the adverse developments in the international financial markets. There was extreme volatility in stock markets, exchange rates and inflation levels during a short duration necessitating reversal of policy to deal with emergent situations. In view of the apparent link between monetary expansion and inflation in first half of the 2008-09, the policy stance of the RBI was oriented towards controlling monetary expansion. This was done by raising cash reserve ratio, repo rate, reverse repo rates. in the second half of 2008-09, the situation changed. there was liquidity crunch in the economy as there was outflow of foreign exchange and virtual freezing of international credit. as a result, monetary stance of rbi underwent abrupt change and it responded to the emergent situation by facilitating monetary expansion through decreases in the cash reserve ratio, repo and reverse repo rates and statutory liquidity ratio.

External Sector

• The foreign trade policy in India was made very restrictive after initiation of the programme of industrialisation in the Second Plan. 
• Only import of capital equipment, machinery, components, spare parts, industrial raw material was allowed. Import of all inessential items was strictly controlled. Import of food grains was allowed from time to time in order to meet the domestic demand for them. This continued for the decade of sixties. 
• In seventies few relaxations were made. In eighties however, special arrangements were made to liberalise imports in a big way. This was done in order to promote exports and increase competitive skills of the exports. Many fiscal and monetary concessions were granted to exporters. Many schemes such as duty draw back scheme, cash compensatory scheme, 100 per cent Export Oriented Units (EOUs) and Export Processing Zones (EPZs) were started to promote exports. A number of organisations such as The Export Promotion Council, Commodity Boards, The Federation of Indian Export Organisations, 
• The Trade Fair Authority, The Indian Institute of Foreign Trade etc. were geared up to promote exports. However, India continued to face deteriorating balance of payments situation in late 80’s and early 90’s. In order to rectify the situation, devaluation was carried out. It was followed by announcement of new foreign trade policy and foreign trade reforms.

Following are the major measures which have been undertaken to reform the external sector of the country:

Exchange Rate Stabilisation

• The rupee was overvalued for most of the period prior to 1991 thus adversely affecting exports. 
• The rupee was devalued [Devaluation means lowering the external value of the country’s currency undertaken by the Government] twice in July, 1991 amounting to a cumulative devaluation of about 19 per cent.
• The RBI used to control the foreign exchange in accordance with the Foreign Exchange Regulation Act, 1973, as amended periodically. 
• With unification of exchange rates in March 1993, transactions on trade account were freed from foreign exchange controls. It was in 1994 that various types of current account transactions were liberalised from exchange control regulations with some indicative limits. 
• Certain capital account transactions were also freed from exchange controls. India is moving towards fuller capital account convertibility in a phased manner.

Foreign Investment 

• Foreign investment had played a very limited role in India’s economy prior to 1991. 
• The restrictions on equity participation in Indian industries, the technology requirements and the then existing industrial licensing policy tended to discourage foreign direct investment (FDI) in India. 
• New industrial policy and subsequent policy announcements liberalised the existing industrial policy. This led to liberalisation of FDI and foreign technology agreements.

Import Licensing

• India’s foreign trade policy was quite complex till the beginning of 1990s. 
• There were various categories of import licenses and ways of importing. The process of liberalisation was given a push with the announcement of EXIM Policy in 1992. 
• The policy allowed free trade of all items except a negative list of imports and exports. 
• The EXIM policies of 1997-2002, 2002-07 and 2004-09 further pruned the list of restricted consumer goods by removing certain items. The number of import licenses has also been reduced.

Quantitative Restrictions

• Quantitative Restrictions (QRs) were removed on 714 items in EXIM Policy of 2000-01 and on remaining 715 items in EXIM Policy of 2001-02. Thus except defence goods, environmentally hazardous goods and some other sensitive goods, gates of domestic markets have been opened to all kinds of imported consumer goods. 
• EXIM Policies of 1997-2002, 2002-07 and 2004-09 further pruned the list and now only very few sensitive items are subject to QRs.

Tariff 

• Prior to 1991, Indian import tariff structure was among the highest in the world. India has lowered its average applied tariff rate from 125% in 1990-91 to 41% in 1995-96 and to 10% in 2007-08.

Export Subsidies

• Direct subsidies are not provided to exporters in India. These are generally provided indirectly through duty and tax concessions, export finance, export insurance and guarantee and export promotion marketing assistance. 
• Export subsidies were thought to be important to boost exports during the period 1980-81 to 1990-91. However, they involved considerable transaction costs, delays and corruption. Since 1991, the emphasis of the export incentive system has considerably changed and modified. 
• The Cash Compensatory Scheme was abolished in July 1991. The EXIM Scrip scheme was abolished with the introduction of the dual exchange rate scheme.
•  A new class of value-based duty exempt import license was introduced in which the exporter could import materials of his choice, rather than pre-defined precise values of certain categories of import, up to the permitted foreign exchange value of the license. 
• A special scheme known as Export Promotion Capital Goods (EPCG) scheme originally introduced in 1990 was liberalised in April 1992 to encourage imports of capital goods. Finally, export income has been exempted from income taxes. EPCG scheme has been further improved by providing additional benefits to the exporters in the EXIM Policy 2004-09.

Special Economic Zones (SEZs)

• Export Processing zone model for promoting exports was not much a successful instrument for export promotion. Therefore, a new policy called Special Economic Zones (SEZs) Policy was announced in 2000. SEZ Act, supported by SEZ Rules, came into effect in 2006. The main objectives of the Act are generation of additional economic activity, promotion of exports of goods and services, promotion of investment, creation of employment opportunities and development of infrastructure facilities. Till May 2009, as many as 568 SEZs have been accorded formal approval and 318 SEZs have been notified. Exports from SEZs in 2008-09 amounted to nearly Rs 100000 crore and employment generated as on 31st march 2009 was more than 387000 persons.

Foreign Exchange Reserves 

The foreign exchange reserves of India consist of foreign currency assets held by the Reserve Bank of India, gold holdings of the RBI and Special Drawing Rights (SDRs). Foreign exchange reserves have been steadily built up from the low level of US $1.1 billion in July 1991 to above US $141.5 billion in 2004-05 and further to US $314 billion at end May 2008.

From FERA to FEMA: Due to acute shortage of foreign exchange in the country, the Government of India had enacted the Foreign Exchange Regulation Act (FERA) in 1973. FERA remained a nightmare for 27 years for the Indian corporate world. It, instead of facilitating external trade, discouraged it. As a result, Foreign Exchange Management Act (FEMA) was made. FEMA sets out its objective as “facilitating external trade and payment” and “promoting the orderly development and maintenance of foreign exchange market in India.”

Other measures 

The Foreign Trade Policy 2004-09 has identified certain thrust areas, like agriculture, handlooms and handicrafts, gems and jewellery, leather and footwear etc. Special schemes have been started to promote their growth. For example, ‘Vishesh Krishi Upaj Yojana’ has been started to promote agricultural exports. Similarly, to accelerate growth in exports of services so as to create a unique ‘Served from India’ brand, the earlier Duty Free Export Credit (DFEC) scheme has been revamped and recast into the ‘Served from India’ scheme.

In order to mitigate the effects of global recession, certain measures were taken in 2008-09. These included, elimination/reduction of import duties on certain goods, simplification of export licensing requirement in certain cases, withdrawing of exemptions from basic custom duty in certain cases, continuation of duty entitlement passbook scheme till December 31st 2009, allocation of additional funds for export incentive schemes and easing of credit terms etc.

Fiscal Policy

Fiscal Policy means policy relating to public revenue and public expenditure and allied matters thereof.
The unsustainable levels of government expenditures, insufficient revenues combined with poor returns on government investments led to fiscal excesses in 1980s.
Fiscal reforms were therefore undertaken to deal with the crisis. They aimed at reducing expenditure, increasing revenues and earning positive economic returns on the investments. Following measures have been undertaken to bring fiscal discipline in the economy.

Tax Reforms 

In August 1991, the Government of India constituted a Tax Reforms Committee (TRC) to recommend a comprehensive reform of both direct and indirect tax laws.

Income Tax Reforms

Following measures were taken to increase collection of income tax. 

• Historically, rates of income tax in India have been quite high, almost punitive. For example, in 1973-94, the maximum marginal rate of individual income tax was as high as 97.7%. This proved to be counter productive. Consequent upon the recommendations of the TRC, the income tax slabs were reduced and the rates themselves have been scaled down. 
• Prior to the assessment year 1993-94, taxation of partnership firm was rather cumbersome. For example, the method of taxation differed according to whether the firm was registered or not under the I.T. Act. Following the recommendations of TRC, 1991, the taxation of partnership firms was drastically modified through the Finance Act, 1992. In the recent years tax policy relating to partnership firms has been further rationalised. 
• The tax rate for domestic companies has been reduced from 40 per cent in early 90’s to 30 per cent now. The tax rate on foreign companies has also been reduced from 55% to 50% (on royality) and to 40% on other incomes. Surcharge is also payable at specified rate over and above the specified limits.
• The basic exemption limits for individuals and Hindu Undivided Families (HUFs) have been increased.
• Requirement of filing of return under the “one by six” scheme has been dispensed with.
• Individuals whose incomes fall below basic exemption limit are no longer required to file returns.
• Dematerialisation of TDS certificates would be made effective from 1.4.2008.
• Scheme for submission of returns through Tax Return Preparers has been introduced.
• Special tax benefits have been allowed to power sector, SEZs and shipping industries.
• Apart from the above many procedural simplifications and rationalisations have taken place to improve tax compliance.

Indirect Tax Reforms: Following are the main measures with regard to indirect taxes.

• Reducing the peak rate of customs duties.
• Rectifying anomalies like inverted duty structure. 
• Rationalising excise duties with a movement towards a median CENVAT (Central Value Added Tax). 
• Introduction of state-level VAT (Value-Added Tax) for achieving a non-cascading, self-enforcing and harmonised commodity taxation regime.
• Increasing productivity of expenditure by laying down monitorable performance indicators. 
• Introducing innovative financing mechanism like creation of a special purpose vehicle for infrastructure projects.
• The Fiscal Responsibility and Budget Management Act (FRBMA), 2003 is in place and emphasises on revenue-led fiscal consolidation, better expenditure outcomes and rationalisation of tax regime to remove distortions and improve competitiveness of domestic goods and services in a globalised economic environment.

Recently further measures have been taken with respect to indirect taxes:

• Replacement of the single point state sales taxes by the VAT in all the states and union territories. 
• Introduction of service tax by the Centre, and a substantial expansion of its base over the years. 
• Rationalisation of the CENVAT rates by reducing their multiplicity and replacing many of the specific rates by ad valorem rates based on the maximum retail price of the products. 
• Plan to introduce Goods and Service Tax (GST) in the coming years. The introduction of GST would entail a restructuring of state VAT and central excise tax. This reform measure would facilitate greater vertical equity in fiscal federalism and reduce cascading nature of commodity tax.

Impact of Economic Reforms on The India Economy

The economic reform process has completed more than one and a half decades and available evidence indicates that the Indian industry has coped extremely well with the new competitive environment after having been sheltered in a protected economy for more than 40 years.
From an average industrial growth rate of 8 per cent in the 1980s despite the slow down in some few years we can see the beginning of the possibility of new sustained growth of over 10 per cent.
All the areas that were subjected to the fresh winds of the competition have indeed fared well. A great deal of re-engineering has taken place. New technologies have been imported at a rapid pace; quality is being upgraded all around.
The removal of licensing has sped up firms’ reactions, increased competition and has made growth the only protection against competition. The removal of import licensing and lowering of the tariffs have helped exporters compete internationally and facilitated value-added exports.
There has been a considerable increase in the investment levels, foreign investment, and reduction in the formalities to be fulfilled after the onset of economic reforms in India.

1. Companies, no longer, feel shy of restructuring, merging and acquisitions.
2. Many industries are now directing their efforts towards the world market.
3. An improvement in work culture has been noticed. The workers have become more quality and cost conscious.
4. Many entities have graduated from being labour intensive to capital intensive.
5. Trade unions and workers have not responded in a much hostile manner to the economic reforms.
6. There has been much awareness and stress on quality and R&D.
7. There has been much awareness and acceptance of the role of scale economies, rapid technological growth and increased productivity.
8. Corporates are going in for aggressive brand building in an increasingly competitive market place.

These positive developments have encouraged the country to think in terms of strengthening these reforms further and move to second generation reforms. But there are certain hurdles which are to be cleared first. These are:

1. Failure to achieve fiscal discipline to the targetted level: Fiscal deficits are still very high and we need to reduce them. This requires,
   (i) Improving tax administration to raise larger revenues.
   (ii) Reducing subsides.
   (iii) Downsizing of government.
   (iv) Bolder privatisation.
   (v) Re-prioritise plan schemes.
2. Failure to implement fully industrial deregulation 
   Dismantling of industrial licensing and opening of industry to foreign investment was an important part of first generation reforms. We have progressed a lot in this direction. But investors still face many problems in implementing projects. Moreover, there are some areas of industrial deregulation where further action is needed. It has been noticed that sectors which are reserved for SSI have grown more slowly than the unreserved SSI sectors. There is a strong need for immediately de-reserving these areas especially the ones which have a strong export potential.
3. Not fully opening the economy to trade: 
   We should clearly identify the major tariff anomalies and lay down a phased programme for their elimination. Besides, our antidumping mechanism and procedures should also be strengthened to ensure that Indian industry is not subjected to unfair competition.
4. Ad hoc and unplanned disinvestment: 
   The programme of privatization and disinvestment has been carried out in an unplanned manner. Lack of transparency w.r.t. these programmes has led to suspicion in the minds of the public. They have begun to question the need of economic reforms and privatization. Therefore, it is necessary that the manner of the disinvestment and the rationale of the specific choice should be made transparent.
5. Slow financial sector reforms 
   The financial sector and banking reforms need to be pushed further.
6. Financing of infrastructure
   Achieving rapid growth of the economy requires a very high quality of infrastructure. Unfortunately, our infrastructure consisting of roads, power, ports, telecommunications, etc. is inadequate. There are severe shortages in quantity and equally serious deficiencies in quality. Public investment will continue to have an important role in all these areas, but the scale of the need is such that it must be supplemented by private investment. But they need to be given sufficient incentives for this.

In addition to the above, we need to

• Extend reforms to the States
• Amend labor laws to bring them in line with other countries
• Strengthen the legal system by scrapping outdated laws, shortening legal procedures so that justice is done in time, bringing clarity in the language of cases/rules so that they are not subject to misinterpretation.

Summary 

Till mid-eighties, the Indian economy was a controlled one in the sense the public sector was given a dominant role and the private sector was regulated with the help of a number of Acts like the Industrial Development Regulation Act, Foreign Exchange Regulation Act, Monopolistic and Restrictive Trade Practices Act and many more. These Acts and regulations strangulated the initiative of the private sector to grow and resulted in inefficiencies, corruption, and mismanagement. To meet the challenge economic reforms were introduced in industrial, financial, external, and fiscal areas. As a result of these reforms, many positive changes have taken place in India such as improved rate of growth, lesser prices, more efficiency, and competition. But failure to have fiscal discipline, ad-hocism, slow financial reforms and not fully opening the economy still mar the progress of economic reforms.