Banking Reforms during Liberalization

The economic liberalization in India refers to the economic liberalization of the country’s economic policies, initiated in 1991 with the goal of making the economy more market-oriented and service-oriented, and expanding the role of private and foreign investment. The basic aim of liberalization was to put an end to those restrictions which became hindrances in the development and growth of the nation.

Pre-Liberalization India

The 1991 reform was not the first attempt at Liberalization. India post-independence was working with a still colonial mindset, following the rules of Fabian Socialism. Still, major problems were being faced –

  • The low annual growth rate of the economy of India before 1980, which stagnated around 3.5% from the 1950s to 1980s, while per capita income averaged 1.3%. At the same time, Pakistan grew by 5%, Indonesia by 9%, Thailand by 9%, South Korea by 10% and Taiwan by 12%.
  • Only four or five licenses would be given for steel, electrical power and communications. License owners built up huge powerful empires.
  • A huge private sector emerged. State-owned enterprises made large losses.
  • Income Tax Department and Customs Department became inefficient in checking tax evasion.
  • Infrastructure investment was poor because of the public sector monopoly
  • License Raj established the “irresponsible, self-perpetuating bureaucracy that still exists throughout much of the country” and corruption flourished under this system

Attempts were made at liberalization in 1966 and 1985. The 1966 attempt was reversed in 1967. The 1990-91 government also took several steps.

Liberalization Reforms

In early 1991, India’s foreign exchange reserves dropped to $1.1 billion, which could just cover five weeks of imports; oil prices escalated sharply because of the Gulf War and remittances from Indian workers in the Gulf declined; and by April 1991, there was a significant withdrawal of non-resident Indian deposits and several Indian banks stopped honoring Indian letters of credit for import transactions. The current account deficit was 3% of gross domestic product (GDP) and by June 1991, the wholesale price inflation was 16%.

In response to the crisis, the Finance ministry led by then finance minister Manmohan Singh, initiated the economic liberalization of 1991 with the support of the then Prime Minister Narasimha Rao. The reforms did away with the License Raj, reduced tariffs and interest rates and ended many public monopolies, allowing automatic approval of foreign direct investment in many sectors.

On 12 November 1991, based on an application from the Government of India, World Bank sanctioned a structural adjustment loan / credit that consisted of two components – an IBRD loan of $250 million to be paid over 20 years, and an IDA credit of SDR 183.8 million (equivalent to $250 million) with 35 years maturity, through India’s ministry of finance, with the President of India as the borrower. The loan was meant primarily to support the government’s program of stabilization and economic reform. This specified deregulation, increased foreign direct investment, liberalization of the trade regime, reforming domestic interest rates, strengthening capital markets (stock exchanges), and initiating public enterprise reform (selling off public enterprises).

In 1991, India embarked into an era of Economic Reforms which led to liberalization, privatization and globalization of the Indian Economy. The financial sector reforms were an integral part to these reforms. The financial sector reforms got momentum with the recommendations of various committees such as Chakravarty Committee (1985), Vaghul Committee (1987) and most notably by Narasimham Committee (1991), which is also known as first Narasimham Committee.

The Motive Behind Liberalization

The objectives behind liberalization of the Indian Economy were as follows:

  • To increase competition amongst domestic industries.
  • To encourage foreign trade with other countries with regulated imports and exports.
  • Enhancement of foreign capital and technology.
  • To expand global market frontiers of the country.
  • To diminish the debt burden of the country.

The Importance of the Year 1991

Prior to 1991, India was more or less an isolated economy, loosely integrated with the economy of rest of the world. The public sector was born out of a planned economy model, which was underpinned by a Nehruvian-Fabian socialist philosophy. In 1991, India embarked on the path of liberalization, privatization and globalization. This injected new energy into the slow growing Indian Economy.

With reference to Banking sector, it was in this year that the first Narasimham Committee gave a blueprint of banking sector reforms. On the basis of these recommendations, the government launched a comprehensive financial sector liberalization programme which included interest rates liberalization, reduction of reserved rations, reduced government control in banking operations and establishment of a market regulatory framework. Another outcome of liberalization was the dismantling of prohibitions against foreign direct investment. Some more outcomes of reforms that impacted the banking sector were –

  • Steps were taken to move to a market determined exchange rate system, and a unified exchange rate was achieved in the 1990s itself.
  • The government also released a slew of norms pertaining to asset classification, income recognitions, capital adequacy etc. which the banks had to comply with.
  • Current account convertibility was allowed for the Rupee in accordance with IMF conditions.
  • Nationalized banks were allowed to raise funds from the capital markets to strengthen their capital base.
  • The lending rates for commercial banks was deregulated, thereby freeing them to lend more or as they saw fit.
  • Also, banks were allowed to fix their own interest rates on domestic term deposits that matures within two years.
  • Customers were encouraged to move away from physical cash, as RBI issued guidelines to the banks pertaining to the issuance of debit cards and smart cards.
  • The process of introducing computerization in all branches of banks began in 1993 in line with the Committee on Computerization in Banks’ recommendations, which had been submitted in 1989.
  • FII (Foreign Institutional Investors) were allowed to invest in dated Government Securities.
  • The Foreign Exchange Management Act (FEMA) was enacted in 1999 and effectively repudiated the Foreign Exchange Regulation Act (FERA) of 1973. FEMA enabled the development and maintenance of the Indian foreign exchange markets and facilitated external trade and payments.
  • The NSE (National Stock Exchange) began its operations in 1994.
  • RBI began the practice of auctioning Treasury Bills spanning 14 days and 28 days.

Since then, the overall thrust of liberalization has remained the same, although no government has tried to take on powerful lobbies such as trade unions and farmers, on contentious issues such as reforming labor laws and reducing agricultural subsidies. By the turn of the 21st century, India had progressed towards a free-market economy, with a substantial reduction in state control of the economy and increased financial liberalization. This has been accompanied by increases in life expectancy, literacy rates, and food security, although urban residents have benefited more than rural residents. World Bank loans had been taken for agricultural projects since 1972, these continued as international seed companies were able to enter Indian markets.

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