Worked example 15 — The crisis and the reforms of 1991, as an episode

Almost every current arrangement on this syllabus dates from one year. The New Industrial Policy is Module 2; the opening of foreign trade and the Foreign Trade Act are Module 4; the tax reform that produced the modern indirect tax structure is Module 3; the shift from prior approval to conduct regulation that produced the Competition Act is Module 1. All four are responses to the same event.

An examiner who asks about 1991 is asking whether you can tell that story as cause, trigger, response and consequence, rather than as a list of measures. This example lays it out in that order.

Independent India built an industrial framework on state direction. Nehru believed a powerful state with a centralised planned economy to be essential if the country was to industrialise rapidly, and the Industries (Development and Regulation) Act in 1951 laid the foundations for this administrative control on industrial capacity. Over time the licensing requirements became increasingly stringent, accompanied by procedures requiring clearance from a number of disparate and uncoordinated ministries.

To pursue import substitution, the Import Trade Control Order of 1955 subjected almost all imports to quantitative restrictions in the form of import licences, supplemented by tariffs at rates that were among the highest in the developing world.

The Industrial Policy Resolution of 1956 identified three categories of industries: those reserved for development in the public sector; those permitted for development through private enterprise with or without State participation; and those in which investment initiative would ordinarily come from private entrepreneurs.

Control tightened after 1969. Banks were nationalised, trade was increasingly restricted, price controls were imposed on a wide range of products and foreign investment was squeezed. In 1973 dealings in foreign exchange and foreign investment came to be regulated by the Foreign Exchange Regulation Act, which virtually shut out the inflow of new technology from abroad in the 1970s and 1980s, particularly where large equity participation was involved. The Government regulated the most basic business decisions for all firms above a certain size: borrowing, investment, capacity utilisation, pricing and distribution.

By the late 1960s and early 1970s the over-restrictive and often self-defeating nature of this framework had begun to be evident, and comprehensive planning was increasingly criticised as targets were not met and many plans were not even implemented. A mild trend towards deregulation began in the early 1980s, and those measures helped GDP growth accelerate to over 5 per cent a year during that decade.

The proximate story is external, but the underlying story is fiscal, and it is the primary-deficit story of Module 3 playing out over twenty years.

| Share of revenue expenditure | 1970-71 | 1990-91 | |---|---|---| | Defence | 34 per cent — the largest component | 15 per cent | | Interest | 19 per cent | 29 per cent — the largest component | | Subsidies | 3 per cent | 17 per cent |

Read the table as a story rather than as three pairs of numbers. Over twenty years, interest and subsidies displaced defence as the largest claims on the Government's running budget. Besides the burden of servicing the public debt, the subsidy burden was also quite great.

That is a revenue deficit compounding. Borrowing to meet running costs makes interest a running cost, which requires more borrowing. By 1990-91 the largest single item of revenue expenditure was the cost of past borrowing — which is exactly what the primary deficit measure of worked example 12 is designed to expose, and exactly the two-part interest-rate cost described there: more paper offered raises the yield, and default risk raises it again, and the higher premium worsens the solvency that caused it.

While India's external debt and expenditure patterns were heading for unsustainable levels, the proximate causes of the balance of payments crisis came from certain unforeseen external and domestic political events.

1. The First Gulf War caused a spike in oil prices, leading to a sharp increase in the Government's fuel subsidy burden.
2. The assassination of former Prime Minister Rajiv Gandhi increased political uncertainties, leading to the withdrawal of some foreign funds.

Note the anatomy, because it is the standard anatomy of such crises and can be transplanted to any other episode an examiner offers:

• a vulnerable underlying position built over a decade — here, a current account financed by borrowing against a deteriorating fiscal position;
• a real shock — an oil price spike hitting an economy that subsidised fuel, so that the shock arrived twice, once on the import bill and once on the budget;
• a confidence shock — political uncertainty withdrawing exactly the capital that had been financing the gap.

Put that beside worked example 14. Disequilibrium means a persistent current account imbalance that has to be financed by borrowing, by attracting capital, or by running down reserves. Reserves are finite. When they run out and lenders stop lending, the country cannot pay for its imports. Trigger 1 widened the gap; trigger 2 removed the financing; the reserves line did the rest.

The Statement on Industrial Policy of 24 July 1991 does not present itself as a rupture; it presents itself as a completion. The winds of change had been with the country for some time, and the industrial licensing system had been gradually moving away from the concept of capacity licensing. What was needed was bold and imaginative decisions designed to remove restraints on capacity creation while ensuring that over-riding national interests were not jeopardised.

The governing principle, and the sentence to quote: the bedrock of any such package of measures must be to let the entrepreneurs make investment decisions on the basis of their own commercial judgement. Enterprises must be able to respond swiftly to fast changing external conditions, and this can be done only if the role played by the government is changed from that of only exercising control to one of providing help and guidance by making essential procedures fully transparent and by eliminating delays.

That is the whole reform in miniature: the State moves from controller to facilitator.

The measures, under their own heads:

A. Industrial licensing will henceforth be abolished for all industries, except those specified, irrespective of levels of investment. Two features matter. Abolition is irrespective of the level of investment — the old thresholds go, not merely soften. And the exceptions are enumerated in an Annexure, so the burden shifts: licensing becomes the exception requiring justification, rather than the rule requiring exemption. The specified industries remain subject to compulsory licensing for reasons related to security and strategic concerns, social reasons, problems related to safety and over-riding environmental issues, manufacture of products of hazardous nature and articles of elitist consumption.

That list is a statement of the legitimate grounds of economic regulation, and it maps almost exactly onto the heads of reasonable restriction a lawyer meets in constitutional law. What the Statement removes is regulation for the purpose of allocating capacity; what it keeps is regulation for the protection of identified public interests.

B. Foreign investment. It was decided to provide approval for direct foreign investment up to 51 per cent foreign equity in high priority industries requiring large investments and advanced technology, with no bottlenecks of any kind in the process. Foreign investment would bring attendant advantages of technology transfer, marketing expertise, introduction of modern managerial techniques and new possibilities for promotion of exports. The 51 per cent figure signifies control: at 51 per cent a foreign investor holds a majority, which under the FERA regime had been effectively unavailable. Discretion was replaced by an announced rule, which the Statement says will go a long way in making Indian policy on foreign investment transparent.

C. Foreign technology. There was a great need for promoting an industrial environment where the acquisition of technological capability receives priority, and this is difficult where the approval process involves unnecessary governmental interference on a case-to-case basis involving endemic delays and fostering uncertainty.

D. Public sector — selective, not wholesale. An answer that treats 1991 as simple privatisation is wrong. Four moves: review the existing portfolio of public investments with greater realism, in respect of low technology, small scale and non-strategic areas, inefficient and unproductive areas, areas with low or nil social considerations, and areas where the private sector has developed sufficient expertise and resources; strengthen enterprises in reserved or high priority areas or generating good profits, with greater management autonomy through the system of memoranda of understanding; disinvest part of the Government's equity holding in selected enterprises in order to provide further market discipline to the performance of public enterprises; and attend to the chronically sick. And the limit: the public sector will not be barred from entering areas not specifically reserved for it. The Statement closes the section with a sentence as much political as economic — the country must be proud of the public sector that it owns and it must operate in the public interest.

Note the stated purpose of disinvestment: discipline, not revenue. Later disinvestment policy was often defended on fiscal grounds instead, and pointing out the difference is a good mark.

E. The MRTP Act. This section matters most to a law student. The Monopolies and Restrictive Trade Practices Act became effective in June 1970; major amendments were carried out in 1982 and 1984, and the threshold limit of assets was raised in 1985. The diagnosis: with the growing complexity of industrial structure and the need for economies of scale, the interference of the Government through the MRTP Act in the investment decisions of large companies had become deleterious in its effects on Indian industrial growth.

The decision has two halves and both must be stated:

• Deregulation of structure. Scrutiny of investment decisions by so-called MRTP companies would no longer be required. The Act was to be restructured by eliminating the legal requirement for prior governmental approval for expansion of present undertakings and establishment of new undertakings, with the provisions relating to merger, amalgamation and takeover repealed and the restrictions on acquisition and transfer of shares appropriately incorporated in the Companies Act.
• Strengthening of conduct control. In its place, emphasis will be on controlling and regulating monopolistic, restrictive and unfair trade practices, with the newly empowered Commission encouraged to require investigation suo motu or on complaints received from individual consumers or classes of consumers.

That paragraph is the direct ancestor of the Competition Act 2002. Being large is no longer the mischief; prior permission is no longer the technique; what is regulated is conduct — anti-competitive agreements under section 3, abuse of a dominant position under section 4 — investigated by a commission that can act on complaint or on its own motion. The line runs from this Statement to the Act studied in Module 1.

Trade. Following the crisis the government commenced on a path of economic liberalisation whereby the economy was opened up to foreign investment and trade, the private sector was encouraged and the system of quotas and licences was dismantled.

Tariffs came down over a decade, and the sequence is worth learning as a sequence:

| Year | Customs peak rate | |---|---| | 1991-92 | all duties on non-agricultural goods above 150 per cent brought down to 150 | | 1997-98 | 40 | | 2002-03 | 30 | | 2003-04 | 25 | | 2005-06 | 15 |

The number of major duty rates fell from 22 in 1990-91 to 4 in 2003-04, and those four rates covered almost 90 per cent of customs collected. Quantitative restrictions went too: free trade in a large number of items became the order of the day, and with the removal of quantitative restrictions on agricultural items and urea the Indian farming community was placed in stiff competition with developed nations.

The sequence — replace quantitative restrictions with tariffs, then reduce the tariffs — is the same tariffication the WTO's Agreement on Agriculture required, and it is the standard shape of trade liberalisation everywhere. A tariff at least leaves the decision to the buyer at a price; a quota removes the transaction altogether.

Tax. Fiscal policy was re-oriented to match. The Tax Reforms Committee provided a blueprint for reforming direct and indirect taxes, its main strategy being to reduce the proportion of trade taxes in total tax revenue, increase the share of domestic consumption taxes by converting the excise into a value added tax, and enhance the contribution of direct taxes to total revenue. It recommended reducing the rates of all major taxes, minimising exemptions and deductions, simplifying laws and procedures, and improving tax administration.

The logic is arithmetical, not ideological: a country that has just been forced to open to trade cannot go on funding itself from customs duties. The peak-rate table above is the revenue problem, and the value added tax that eventually became the Goods and Services Tax is the answer to it.

It did: abolish industrial licensing except for a listed few; open majority foreign equity in high priority industries; ease foreign technology agreements; re-orient the public sector towards review, autonomy, disinvestment and competition; convert monopoly regulation from prior approval into conduct control; dismantle quantitative restrictions and cut tariffs; and shift the tax base from trade to domestic consumption and income.

It did not: abolish the public sector or bar it from unreserved areas; remove regulation for security, safety, social or environmental reasons; or, by itself, touch agriculture, labour law or the tax system — which is why the reform is described as a reform of industrial policy, and why the phrase used for the whole package is liberalisation, privatisation and globalisation, of which this Statement supplies mainly the first and part of the second.

The Government's own framing was that these measures complement the other series of measures being taken in the areas of trade policy, exchange rate management and fiscal policy: the industrial policy was one component of a package, not the whole of it.

Agriculture was exposed. Chapter 7 records that after the reforms removed restrictions and the protective licensing regime, and with quantitative restrictions on agricultural items and urea removed, the Indian farming community faced stiff competition from developed nations. India's answer in WTO negotiations rests on the Aggregate Measurement of Support: India's product-specific AMS was negative — for eighteen major commodities the product-specific support during the base period was minus US$18.11 billion, or minus 26.1 per cent of the value of crop-sector output, minus 34.36 per cent in 1995-96 and minus 28.6 per cent in 2000-01 — which shows that various controls on domestic as well as external trade kept domestic prices of major crops below world prices. India was taxing its farmers in the WTO's sense, not subsidising them.

The export composition changed, and the reason is often misread. Agriculture and allied products contributed 31.7 per cent of total export earnings in 1970-71, 30.6 per cent in 1980-81, about 20.33 per cent at the 1996-97 peak of the later series, and about 12 per cent by 2003-04. The declining trend in the relative share of agriculture is primarily due to increased non-agricultural exports, not to any collapse in farm exports. And the major devaluation of the rupee that followed the crisis had a much greater impact on the value of exports of clothing, textiles and other manufactured goods than on exports from the agricultural sector — which is the elasticity of Module 1 applied to trade: a devaluation helps sectors differently, according to how price-sensitive their foreign buyers are.

Two lessons for an answer: a falling share is not a falling quantity, because the denominator grew; and a devaluation is not a uniform stimulus.

India's foreign exchange reserve level in 1991, the size of the external debt at the time, the terms of any assistance received, and any dated chronology of the crisis beyond the two triggers named in step 3 are not given here. Do not supply the familiar reserve figures from memory. The fiscal composition table, the triggers, the Statement's paragraphs, the tariff sequence and the AMS figures are all sourced and may be quoted.

1. The structure: IDRA 1951 licensing, IPR 1956's three categories, the Import Trade Control Order 1955's quantitative restrictions and very high tariffs, MRTP 1970, FERA 1973 — the Government regulating borrowing, investment, capacity, pricing and distribution for every large firm.
2. The cause: revenue expenditure composition shifted from defence 34 / interest 19 / subsidies 3 per cent in 1970-71 to interest 29 / subsidies 17 / defence 15 by 1990-91 — interest became the largest running cost.
3. The triggers: the First Gulf War oil spike hitting the fuel subsidy, and political uncertainty after Rajiv Gandhi's assassination withdrawing foreign funds. Vulnerable position + real shock + confidence shock.
4. The response: the Statement of 24 July 1991 — licensing abolished except for a specified list irrespective of investment; 51 per cent FDI in high priority industries; technology approvals eased; public sector reviewed, given autonomy through memoranda of understanding, and partly disinvested for discipline; MRTP prior approval repealed and replaced by conduct control — the ancestor of the Competition Act 2002. Plus tariff cuts 150 → 15 per cent, rates 22 → 4, and a tax shift from trade taxes to domestic consumption and direct taxes.
5. The consequences: agriculture exposed to competition, with India's product-specific AMS negative, and agriculture's export share falling 31.7 → about 12 per cent because non-agricultural exports grew — not because farm exports fell.