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India is walking on one leg because 1991 reforms missed banking & finance

Restrictions on banking led to limited capacity for new entrepreneurs to have access to resources. It allowed the old elite to continue dominating. This order must be shaken up now.

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India’s liberalisation of trade and industry in 1991 was a serious reform that gave spurt to growth. But it was fundamentally incomplete.

The move left critical parts of the economy, which suited the needs of the centrally planned economy built by Jawaharlal Nehru and Indira Gandhi, unreformed. One such critical area was banking.

What reforms mean

The term ‘economic reform’ typically denotes the removal of restrictions that governments impose on economic activity, rather than the English usage of the word reform — which means to change something in order to improve it.

So in a country like the US, it may be said that the tax system needs to be reformed, implying that the tax system needs improvement. But in an emerging economy, economic reforms undertaken mean that some restrictions imposed in the days of central planning are removed.

Therefore, when we say economic reforms started in India in 1991, we primarily mean a removal of restrictions on sections of the economy, like on industry.

Until 1991, a firm could not produce in India unless a specific license was obtained by it for that particular good, and for the quantity it could produce. In trade no one could import goods and services unless they obtained a license from the Ministry of Commerce for — the product, the quantity, and the import destination.

These restrictions, which did not permit people to start producing something if they wished to, even if they followed all the laws and regulations such as those pertaining to labour or pollution, were based on the government’s estimates of how much it thought a certain amount of the product ought to be produced.

So even if people wanted cars and it would have been profitable to produce cars, and someone had the money to invest in a factory that produced cars and could have made profits selling to those who wanted to pay for them, and then invest even more, perhaps, in making more cars and exporting them, they were not allowed to do so. 

The restrictions clearly meant that these additional cars would not be produced, jobs would not be created, investment would not happen and exports would not take place. 

Liberalisation in 1991 changed that ‘licence raj’ by simply removing the restriction that you could not produce without permit.

Also read: India needed a crisis to reform. It got one in 1991, thanks to Nehru & Indira’s Soviet model

How finance was left out

One big element was still missing in this picture. And that was about who could produce — whether the government was merely allowing existing companies to do new things, or whether it was actually unseating the elite that had dominated the economy until then.

When people set up factories and invest, they need money. While India allowed existing companies to raise capital by selling shares in equity markets that were created and later modernised in the 2000s, new entrants didn’t meet the requirements.

The restriction on banking that only the government could own banks continued even after July 1991. This led to limitations on new entrepreneurs in having access to resources.

The pool of capital that banks were able to mobilise remained limited due to the mobilisation capacity of public sector banks.

This was a bit like telling the industry that only existing industries could expand more. 

Something similar had been tried in the 1980s under broad-banding when the government relaxed the licenses required for capacity expansion in an industry. This had clearly not worked as the inefficiency built into existing factors didn’t go away simply because they were allowed to produce more. The lack of innovation and low productivity had continued. With the entry of new banks restricted even after 1991, resource mobilisation remained limited.

This hit the potential newcomers most. Existing banks had a preference for their traditional customers, further helping the incumbents to borrow more. They were also already better off because they could raise money in stock markets by selling their shares.

When foreign investors were allowed into India later, they could buy these shares and so existing large Indian companies were able to raise both domestic and foreign equity.

Even when foreign direct investment (FDI) was allowed, government regulation mostly allowed foreigners to invest in joint ventures (JVs) with Indian companies, and later if they wanted to set up another venture independently, or with another Indian company, they needed permission of the original Indian JV partner. All these came together to work well for existing companies.

During the pre-liberalisation period, when licenses had to be obtained, such companies were the ones that could influence governments and politicians and get licences. Clearly, these were not the most productive, efficient, honest or innovative companies.

The restrictions on Indian finance, FDI policy and restrictions on banking continued to tilt the balance in favour of the same companies that had dominated India for a long time.

While some old private banks existed, they were very small. Some new private banks were allowed later, but the sector was largely PSU dominated and continued working with the mindset of central planning.

The culture of pleasing bosses coupled with little competence or incentives to push for lending to new and innovative projects didn’t change.

Banking regulator Reserve Bank of India and the government too continued with the old central planning system in banking by telling banks to lend a certain percentage to “priority sectors”, as defined by the government, and another certain percentage to the government and so on.

Also read: If we raise duties to make Indian industry competitive, we’ll end up close to 1991: Montek

Time for shake-up

This system is still in place, along with the problems of lending to unsuitable projects at the directions of politicians and civil servants. Taxpayer money continues to be funneled into such banks year after year even as they make losses.

Banking reform remains one of the most important unfinished agendas of economic reform in India.

Now that the latest budget talks about privatisation of public sector banks, there is, hopefully, serious political capital behind this reform. The revival of investment in India requires banking reform. Until then India is walking on one leg.

Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.

Also read: Why did India not fulfil its economic potential? New book outlines ‘economics of non-performance’


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