Indian Financial crisis of 1991


A look at Indian economy as it faced one of its worst financial crisis since independence.


In India, 1991 is known as the watershed year. This is the year when major steps were taken to liberalise the Indian economy. Various policies were implemented, and many were discarded. This change came about due to the Balance of Payments crisis in 1991. Foreign exchange reserves were at their lowest, the Indian government was in debt, so much so that it had to trade up all of its gold reserves to the IMF to secure a loan of $2.2 billion. (Chandrasekhar, 2008)

Since India's independence in 1947, up to the financial crisis of 1991, Indian economy had mainly focused on becoming a self reliant sovereign with policies based on import substitution and development of heavy industries. The growth of expenditures by the government up until the crisis can be partially explained by the political instability of the late 1970's as well as the oil shock of 1979-80. This meant that while revenue was low, expenditure was still increasing at a rate greater than the revenue. This increase of expenditure more than revenues meant that there were fewer resources for investment.

This paper will try to look at the various economic reforms that took place due to the crisis and also the changes in development that occurred during the same period. According to Srinivasan (2004: p.8) development can be broadly defined as the “process of enhancing the capability and opportunity of individuals in the society so they can reach their full potential of growth and contributions”. For development to occur, it is important to have adequate level of income, education and health in a society.

Industrial Policy of India

The first Industrial Policy Resolution passed in 1948 was broad in its scope and direction but an important distinction had been made with regard to the industries which would be developed by the public sector and those which would be developed by the private sector. This resolution paved the way for the Industrial Policy Resolution of 1956 which was more comprehensive and focused. The Industrial Policy Resolution of 1956 laid emphasis on heavy industries and was shaped by the Mahalanobis Model of Growth. Due to the scarcity of resources and underdeveloped private sector this policy directed the public sector to undertake the development of the industries. All industries that were of basic and strategic importance along with those requiring huge investments came under the ambit of the public sector. Another objective of this policy was to remove the regional disparities by developing those regions which had a low industrial base. This policy was a landmark and formed the basis for subsequent policies. The objective of The Industrial Policy of 1991 was to unshackle the Indian industry from bureaucratic controls by removing many quantitative restrictions and reservations, improving productivity through automatic approval of technological agreements related to high priority industries, and promoting development of low industrialised regions by giving incentive to industries to locate in those areas. (Jadhav, 2005)

Trade Policy of India

Before liberalisation the trade policy in India was characterised by high tariffs, import restrictions, import licensing and quantitative restrictions. Import of manufactured consumer goods was completely banned. This period is also known as the “licensing raj” a term coined by Indian statesman Chakravarthi Rajagopalachari who opposed it. He believed that it would lead to corruption and economic stagnation. These practices not only sheltered the domestic producers from foreign competition but also led to wastefulness and low productivity.

After the crisis, the Indian government undertook many trade reforms. Import licensing was abolished completely by 1993. And, with a shift towards market determined flexible exchange rate system import licensing too was removed. The government argued that any impact on the balance of payments account due to removal of the import licensing could now be dealt with a change in the exchange rate. Removal of quantitative restrictions on capital and intermediate goods was welcomed by the Indian industry, as not only was the number of domestic producers small but also this would increase competition and hence, productivity. However, quantitative restrictions on final consumer goods were harder to remove due to the large number of domestic producers who would be affected. All quantitative restrictions were finally removed in 2001 due to a ruling by the World Trade Organisation dispute panel on a complaint filed by the United States.(Ahluwalia, 2002)

Legislative Changes

During the period leading up to the crisis many new acts were enforced one of them being the Monopolies and Restrictive Trade Practices Act (MRTP) one of the most controversial acts. This act was brought into effect in 1969, to prevent the concentration of economic power which may prove detrimental to society. It regulated the mergers, acquisitions, amalgamations, and appointment of directors of dominant undertakings. This act was made redundant in July 1991 and was replaced by the Competition act in 2002. Unlike the MRTP Act the Competition Act aimed to promote competition and thereby lead to a higher level of efficiency. It also did not frown upon dominance per se, but only took action if that dominance was abused. It was also clearer on the actions that would be taken against offenders.(Legislative Dept. Government of India)

Another act which was of prominence during the period is the Foreign Exchange Regulation Act (FERA), which came into effect in 1973. This act came into being due to the shortage of foreign exchange in India. This act aimed to conserve and properly utilise India's foreign exchange resources. However, it made any offence committed under it a criminal offence. This act was repealed in 1999, as it had become incompatible as liberalisation took place. The Foreign Exchange Management Act (FEMA) was passed in 1999, replacing FERA. This Act was more pro-liberalisation and any offences under it were civil offences.(Legislative Dept. Government of India)

Exchange Rate Regime

The Indian Exchange rate system followed up until the time of the crisis was a managed float exchange regime, with the Rupees real effective exchange rate (REER) placed on a controlled, floating basis and linked to a “basket of currencies” of India's major trading partners. This regime meant that the Rupee was highly overvalued. During the crisis, it was found that if India was to get out of the crisis it would need to devalue the Rupee substantially, and the adjustment took place in two stages on 1st July and 3rd July, 1991. After this adjustment India started to follow the Liberalised Exchange Rate Management System (LERMS) which placed an implicit tax on exports. Hence, this too was discarded in 1993 by the Reserve Bank of India (RBI) in favour of the Unified exchange rate system. (Sultan, n.d.)



The above graph shows the changes in the exchange rate between the Rupee (INR) and the Dollar starting from the year 1985 to 1995. Keeping the Dollar fixed at $1, the INR went from Rs.12.36 to a dollar in 1985 to Rs.22.74 in 1991 and depreciated to Rs.32.42 to a dollar in 1995.

Capital Flows

Before India's liberalisation which began in 1991, Capital flows to India were restricted to aid flows, NRI deposits and commercial borrowings. There was very little Foreign Direct Investment, and close to nil Foreign Portfolio Investment up until the reforms of 1991. Table 2 illustrates the above composition of Capital flows to India starting from year 1986 up to 2001. Since the reforms however, capital flows to India saw a significant increase, a trend that breaks away from that of the previous two decades. Table 3 below shows the increase in the net capital inflows from $7.1 billion in 1990-91 to $45.8 billion in 1996-97 and reaching $108 billion in 2007-08. (Mohan, 2009)


Source :Kohli: Capital Flows and their Macroeconomic Effects in India, IMF Working paper, 2001


Source: RBI Annual Report on Composition of Capital (Net), 2009

Fiscal Discipline, Savings and Investment

During the crisis of 1991, India's financial stability had come under the scanner. Statistics have shown that the crisis was largely due to the growing government expenditure of the 1980's. An increase in government expenditure meant that it was borrowing more and more from the Reserve Bank of India (RBI). This led to an expansionary effect on the money supply.

M x V = P x Y

Hence an increase in money supply meant that price levels too would have to increase leading to inflation. The fiscal deficits of the government rose from 9% of GDP in 1980-81 to 12.7% of GDP in 1990-91. This deficit had to be financed through borrowings and this meant that government debts too rose rapidly, along with an increase in the percentage of interest payments to GDP. (Ghosh, 2006)

The immediate step after the onset of the crisis was to reduce the fiscal deficit. The combined fiscal deficit of the central and state governments was reduced from 9.4% of GDP in 1990-91 to 7% of GDP in 1992-93. The Balance of Payments crisis was over by 1993. After the crisis public savings deteriorated from +1.7% of GDP in 1996-97 to -1.7% of GDP in 2000-01. This was reflected in the fiscal deficit too reaching 9.6% of GDP in 2000-01, which was the highest in the developing countries. It was also of significance because the public debt to GDP ratio too was at 80%. Also this debt was not used to finance any public investments which had remained constant. (Ahluwalia, 2002)

Agricultural Reforms

At the time of the reforms almost 60% of the Indian population depended on agriculture for their livelihood. Hence, a common critique of the reforms followed by India has been that it focused largely on the Industrial and Trade policy while neglecting the Agricultural sector. Critics point out the deceleration of growth in the second half of the 1990's from 4.3% of GDP from 1992-97 to 2.3% between 1997-02 is proof of this neglect. However, this criticism doesn't hold under scrutiny, as in the same period agricultural exports increased from Rs.60 billion in 1990-91 to Rs.398 billion in 2005-06 (Ministry of Commerce, Government of India, 2008). This can be owed to the depreciation of the Rupee, and the reduced protection of the industry.

Although agriculture benefited from the reforms, it suffered in other ways. There was a decline in public investment in irrigation, water management, soil conservation, and rural infrastructure which are essential for agriculture. The low investment in agriculture has led to stagnation and hence, the demand for unskilled labour too has not increased much, leading to a slower decline in poverty. The reason for the stagnation is partially due to the deterioration in the fiscal position of state governments combined with politically motivated subsidies like fertilizer subsidy and under pricing of power and water. This benefits the rich farmers while negatively affecting the environment and the poorer farmer's incomes. A reduction in subsidy would not only increase revenues but these revenues could be used to finance rural development projects. However, reduction in subsidy is something that no person irrespective of party affiliations will ever want to discuss as these are politically sensitive issues. ( Jha, 2007)

Impact of Economic Reforms on HDI

The Human Development Index (HDI) has its origins in the Human Development Reports (HDR) of the United Nations Development Programme (UNDP). This index was developed in 1990 by Pakistani economist Mahbub ul Haq, and Indian economist Amartya Sen. The HDI unlike other indices, has its focus on three major aspects of development. Firstly, it measures life expectancy at birth. Secondly, it takes into account adult literacy combined with the gross enrolment ratio, i.e. the number of students enrolled in primary, secondary and tertiary levels of education, regardless of age. Thirdly, it considers the GDP per capita in purchasing power parity (PPP), which is a reflection of the standard of living of the population being studied. The three aspects all have equal weightage and combined together give an idea about the development of a country. The three aspects combined together are measured between a range of 0 to1, with 0 being the lowest and 1 being the highest Human Development Index. (UNDP Human development Report)


Source: UNDP Human Development Report

The table above shows the movements in the HDI of India starting in 1990 up to the year 2000. As is graphed, the changes in HDI have not been very significant over the decade, although the corresponding changes in GDP have been significant. Below are some reasons for this low rate of increase in the HDI.

The population boom

India's population crossed the one billion mark by 2000, and the 2001 census put India's population at 1,026.44 million. India's population between 1901 and 2001 has seen an increase of almost 789 million. Also, out of this increase 85% of it occurred during the second half of the century, from 1951 to 2001, and only 15% was added during the first half, i.e. 1901 to 1950. This disproportionate growth in population can be attributed to the rapid fall in death rate as medical advancements were made to control communicable disease like malaria, cholera, small pox etc. The rate of increase of population could have been higher, had it not been for the decline in birth rate which had been stagnant almost until the late seventies. Since the seventies the birth rate has been declining, however it has been disproportionate within India. Few states like Tamil Nadu, Goa, Kerala, Andhra Pradesh, Karnataka, West Bengal, Maharashtra, Gujarat and Punjab have seen a rapid fall in the birth rate. While states like Bihar, Haryana, Rajasthan, Uttar Pradesh and Madhya Pradesh have had a much slower pace of decline in the birth rate. (Srinivasan, 2004)

Despite the fall in death rate, followed by a slower but nonetheless decline in birth rates across India. The growth rate went to a high of almost 2.2% in the late seventies and early eighties before declining in the following decade. This process is also known as the Demographic Transition, which occurs in all populations.

Employment Generation & Poverty Reduction

With a decline in the rate of increase in population, there has also been a subsequent decline in the percentage of population under the poverty line. In India the poverty line is estimated on the basis of Head Count Ratio, i.e. on the basis of the cost of food items required to meet the minimum calorie needs of a family. The Planning Commission of India estimated that the percentage of people below the poverty line in 1977-78 was almost 48% which decline thereafter to 26.1% in 1997-98. Starting in 1980's the Government of India has emphasised on programmes to alleviate poverty and provide basic needs at stable and low prices, provide incentive to industries to locate in backward areas, and hence give a boost to the local infrastructure and provide employment opportunities. The total money spent on such programmes is estimated to have been over 10% of the planned budget expenditure over 1980 and 1990. The government started antipoverty programmes like the National Rural Employment Programme which was initiated in the 1980, and the Rural Landless Employment Guarantee Programme, first formulated in 1983 to address the plight of the rural poor by expanding their employment opportunities. The Central Government also delegated the work of implementation of the various antipoverty programmes, land taxation, reform, and ownership policies to the State government. And although the Central government exerts political and financial pressure on the State government to effectively implement the policies, there remain many bureaucratic hurdles and corruption which sometimes retards or slows down the impact of the policies. (Library of Congress, 1995)

As per The Government of India, poverty line for the urban areas is currently at Rs.296 per month and in the rural areas its Rs.276 per month. This is the minimum wage a person would need to earn in a month to consume 2200 calories in India. Although poverty has been on the decline in India, again this decline has not been equal across the states, with many of the northern states, like Bihar, Uttar Pradesh, Rajasthan, Haryana, lagging behind and states like Kerala, Goa, Tamil Nadu, Maharashtra, Karnataka, West Bengal, Gujarat faring much better than the national average.

Health & Life Expectancy

The Public expenditure on health in India is dismally small, and the reforms have had little to no impact in improving this situation. Even in 2001 public expenditure in health was at a mere 0.9% of GDP while private expenditure on health was 4.2% of GDP. Despite the known merits of having a high public expenditure in health, the government has taken few steps to ensure better health services, facilities and infrastructure. Hence, there has been greater reliance on the private sector to provide these facilities which denies easy access to the poor. The presence of externalities as well as information asymmetry is reason enough for the state to intervene and correct this market failure, on the grounds of both equity and efficiency.(Chandrasekhar and Ghosh, 2006) Table 5 shows the health expenditure by the Central and State government as a percentage of GDP.


Source: Chandrasekhar and Ghosh; Health Expenditure in India, The Hindu Business Line, 2006

As is clear from this table, the combined expenditure by the Central and State governments even in the mid-1980's was more than 1% of GDP, as compared too 0.9% in 2001-02. Although we do see an increase in 2003-04 the expenditure as a part of GDP has not changed much.

Also what is of concern is that a lot of the expenditure incurred has been towards the revenue expenditure, i.e. like payments of salaries etc rather than towards building better infrastructure and facilities, i.e. capital expenditure.(Chandrasekhar and Ghosh, 2006)

Health facilities and infrastructure have a direct relation to the life expectancy, if more of the population has access to good and cheap health care facilities then the citizen of that country are more likely to have a higher life expectancy. However, looking at the UNDP reports, India in comparison to other countries has not seen a significant change in the life expectancy at birth in the decade since the reforms started. In 1990, according to the UNDP report, the life expectancy in India was 59 years, which has only reached 62.9 years by 2000. This clearly reflects the negligence of the Indian government to address the issue of low public expenditure on health, especially as the poorer sections of the society have little access to private health care facilities.


Source: UNDP Human Development Report

Adult Literacy

As stated by Rawat and Chauhan (2007) education is an engine of economic growth and social change. It helps in the progress of a country by bringing to the front revolutionary ideas and changes. Education significantly affects poverty, income distribution, health, fertility, mortality, and the overall quality of life. It is also one of the human rights set out in the U.N. Charter.

India realised the importance of education and set up the National Policy on Education (NPE) in 1986 to help eradicate illiteracy. The target was to provide elementary education to every citizen. This is being done through programmes like the Sarva Shiksha Abhiyan (SSA), Mid Day Meal where all primary students are provided with food for free, and the District Primary Education Programme (DPEP). In 1951 India's literacy rate was 18.3% which has grown to 55.7% in 2000. However, similar to the health sector, education too has seen a decline in public spending, with a consequent rapid privatisation of education. This has not only meant a decline in the quality of education but has also made education less accessible to the poor. This has come due to inadequate state expenditure followed by downgrading of many government institutes and their services, and the profitability of private spending on education. The combined expenditure by the central and state governments on education was only 3.7% of GDP in 2003-04 as against the target expenditure of 6% for the period.(Rawat & Chauhan, 2007)


Source: UNDP Human Development Report

In the National Family Health Survey (NFHS) conducted by the International Institute of Population Sciences (IIPS), Mumbai designated by the Ministry of Health and Family Welfare (MOHFW) to conduct the survey. It has been found that the states that fared worst in the literacy were also the same that did badly in other areas, like life expectancy and were also the poorer states of India. The national average of literacy rate in India was at 67.6% while states like Bihar, Uttar Pradesh, Rajasthan and Madhya Pradesh had literacy rates below the national average. And the states like Goa, Kerala, Karnataka, Maharshtra, Tamil Nadu, Himachal Pradesh and West Bengal had literacy rates above the national average. This in itself reflects the effect that a high level of literacy has on income distribution, health, life expectancy and the overall quality of life. (NFHS, 2007)


After looking at the above it can be concluded that although India has witnessed many economic reforms and removal of controls after the initial crisis in 1991, especially those relating to Industrial and Trade sectors. These reforms have not been implemented fully and hence, have not realised their full potential. India is an agrarian society with almost 60% of the workforce engaged in agricultural activities. This should be reason enough to increase public expenditure in agriculture and make it more efficient, and increase the rate of employment to help alleviate poverty. Similarly, public expenditure in Health and Education too needs to increase for India to see a higher level of human development. As has been discussed above Education and Health directly affect the income distribution, life expectancy and overall quality of life. The low levels of public spending in these areas, along with higher private expenditure has meant that the poor of the country are deprived of a good quality of health and education due to their high cost. India still has a long way to go to ensure equality in opportunity and quality of life to its citizen.


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2. Chandrasekhar, C.P. (2008) ; Financial Liberalisation and the New Dynamics of Growth in India, Third World Network

3. Chandrasekhar, C.P. & Ghosh, Jayati (2006) ; India's potential demographic dividend, The Hindu Business Line

4. Ghosh, Arunabha (2006) ; Pathways through financial crisis: India, Global Economic Governance

5. International Institute of Population Sciences, NFHS (2007)

6. Jadhav, Narendra (2005) ; Indian Industrial Policy since 1956

7. Jha, Raghbendra (2007) ; Investment & Subsidies in Indian Agriculture, ASARC Working Paper

8. Library of Congress (2005) ; Antipoverty programs by Indian government

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13. United Nations Development Programme, Human Development Reports

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