The Three Phases of Indian Economic Policy

What it cost. Slow growth, often described as the Hindu rate of growth of about three and a half per cent a year; shortages and waiting lists for ordinary goods; industries that had no reason to reduce costs or improve quality because imports were shut out and entry was licensed; and, by 1991, an economy that could not pay for what it needed to import.

The crisis of 1991

This is the hinge, and it should be described in a sentence or two of causes and a sentence of consequence.

The causes. A widening fiscal deficit through the 1980s financed partly by borrowing abroad; a current account deficit; the Gulf war of 1990, which raised the oil import bill and cut remittances from West Asia; political instability; and a downgrade that closed India's access to commercial borrowing.

The consequence. Foreign exchange reserves fell to a level covering only a few weeks of imports. India borrowed from the International Monetary Fund and pledged gold. The response was a set of reforms announced within weeks of each other in July 1991: devaluation of the rupee, the Union Budget of 24 July 1991, and the Statement on Industrial Policy of the same date.

Phase two, from 1991: liberalisation, privatisation, globalisation

The three words, defined, because MU's Module II uses them.

• Liberalisation: removing the licences, permits and quantitative controls on domestic economic activity.
• Privatisation: reducing the role of the public sector, by selling shares in public undertakings, opening reserved industries to private entry, or transferring management.
• Globalisation: integrating the domestic economy with the world through trade, capital flows, technology and, to a limited extent, labour.

What was done, in the four heads the 1991 Statement itself used, treated in full in [The New Industrial Policy 1991]: industrial licensing abolished except for a short list; the public sector schedule cut sharply; automatic approval for foreign equity up to 51 per cent in specified industries; and the pre entry scrutiny of large undertakings under the MRTP Act removed.

What was done outside industrial policy. Tariffs cut steeply and quantitative restrictions on imports phased out; the rupee made convertible on the current account; the capital market opened to foreign portfolio investment and given a statutory regulator in the Securities and Exchange Board of India; interest rates deregulated; and private banks and insurers permitted.

Phase three, roughly since 2014: the State returns, differently

The third phase is not a reversal of the second. Licensing has not come back and the public sector has not been re expanded. What has changed is what the State does with its own money and its own authority.

Its principal features.

• Public capital expenditure as the growth instrument. The Economic Survey 2025-26 records the share of capital spending in total central government expenditure rising from about 12.5 per cent in FY20 to 22.6 per cent in FY25 on provisional actuals, with effective capital expenditure rising from about 2.6 to 4.0 per cent of gross domestic product.
• Digital public infrastructure. Identity, payments and data layers built by the State and used by private firms, which is why digital payment volumes now appear in the national accounts discussion at all.
• Direct benefit transfer. Subsidies and benefits paid into bank accounts rather than delivered as cheap goods, which changes the whole structure of the subsidy discussion in [The Sources of Public Revenue].
• A single indirect tax. The goods and services tax from 1 July 2017, treated in [Indirect Taxes and the Goods and Services Tax].
• New economic statutes, principally the Insolvency and Bankruptcy Code 2016, and the consolidation of labour legislation into four Codes.
• Production linked incentives and strategic resilience, which is a return of industrial policy in a new form: not licences deciding who may produce, but subsidies encouraging domestic production in selected sectors.

The three phases compared

A worked example: three answers to one problem

The problem. A district needs 200 megawatts of additional electricity.

The phase one answer. The State Electricity Board applies for an allocation in the Plan. A public sector unit builds the plant with equipment made by another public sector unit, because importing a turbine requires an import licence and foreign exchange that is rationed. The tariff is set administratively and is below cost for farmers, with the loss carried by the Board.

The phase two answer. The State invites private bids to build and operate the plant. Foreign equity is permitted, so the turbine can be imported or made under a foreign technology agreement. A regulatory commission fixes the tariff by a published method rather than by administrative order.

The phase three answer. The State builds the transmission line and guarantees the offtake; a private developer builds a solar plant chosen by reverse auction; the subsidy to poor consumers is paid to them directly rather than by holding the tariff below cost; and the domestic manufacture of the panels is encouraged by a production linked incentive rather than required by a licence.

What the example shows. The question, who builds it and at what price, receives a different answer in each phase, and each answer solves the previous phase's problem while creating one of its own.

What beginners get wrong

"1991 was a change of ideology." It was, in the first instance, a response to a balance of payments crisis. The intellectual case had been made for years; the crisis is what made it politically possible.

"Liberalisation means the government withdrew." Government spending as a share of gross domestic product did not fall. What changed was what the government did: less licensing and production, more regulation, transfers and infrastructure.

"Planning ended in 1991." The Planning Commission continued until it was replaced by NITI Aayog on 1 January 2015, which is [NITI Aayog: Why It Replaced the Planning Commission]. Five Year Plans ended with the Twelfth Plan.

"The reforms of 1991 were completed in 1991." They were begun. Tariff reduction, capital market reform, banking reform, the goods and services tax and the insolvency code all came later, and several parts, notably in land and labour, remain contested.

Limits of this periodisation

The dates are approximate. Liberalisation began before 1991, in the industrial policy changes of 1985 and 1986, and the third phase has no agreed starting point.

It is a central government story. Much of what determines whether a factory opens, land, electricity, water, local approvals, is decided by a State government, and the States have moved at very different speeds.

Agriculture is largely outside it. Farm policy has changed far less than industrial policy, which is one explanation for the gap in [Structural Change in the Indian Economy].

Quick revision

1. Phase one, 1950 to 1990: Planning Commission from March 1950; Industrial Policy Resolution 1956 with its three schedules; Industries (Development and Regulation) Act 1951 licensing; small scale reservation; import substitution; MRTP Act 1969; bank nationalisation 1969 and 1980.
2. Achievements: a diversified industrial base, technical institutions, a national banking system, foodgrain self sufficiency. Costs: slow growth, shortages, no pressure to improve, and a balance of payments crisis.
3. The 1991 crisis: fiscal and current account deficits, the Gulf war, political instability, reserves down to a few weeks of imports, borrowing from the IMF.
4. Phase two: liberalisation, privatisation and globalisation. Licensing abolished except for a short list, public sector schedule cut, foreign equity permitted, tariffs cut, rupee made current account convertible, SEBI given statutory status.
5. Phase three, roughly from 2014: public capital expenditure (capital spending from about 12.5 per cent of central expenditure in FY20 to 22.6 per cent in FY25 PA), digital public infrastructure, direct benefit transfer, the goods and services tax from 1 July 2017, the Insolvency and Bankruptcy Code 2016, the labour Codes, and production linked incentives.
6. Planning did not end in 1991: the Planning Commission was replaced by NITI Aayog on 1 January 2015.

Test yourself

1. Describe the main features of Indian economic policy between 1950 and 1990. The State occupied what were called the commanding heights of the economy. The Planning Commission, established by Cabinet Resolution in March 1950, drew Five Year Plans from 1951. The Industrial Policy Resolution of 1956 divided industry into three schedules, reserving seventeen industries to the State and requiring the State progressively to lead in a further group. The Industries (Development and Regulation) Act 1951 required a licence to establish an undertaking, to expand capacity substantially or to make a new article. A long list of products was reserved for small scale units. Trade policy was one of import substitution, enforced by quantitative restrictions, import licensing and high tariffs. The Monopolies and Restrictive Trade Practices Act 1969 required large undertakings to seek approval before expanding, and the major banks were nationalised in 1969 and 1980.

2. What caused the crisis of 1991 and what was the immediate response? A fiscal deficit that had widened through the 1980s and was financed in part by external commercial borrowing; a persistent current account deficit; the Gulf war of 1990, which raised the oil import bill and reduced remittances from West Asia; political instability; and a credit downgrade that closed access to further commercial borrowing. Foreign exchange reserves fell to a level covering only a few weeks of imports, and India borrowed from the International Monetary Fund and pledged gold. The immediate response, in July 1991, was devaluation of the rupee, a reforming Budget, and the Statement on Industrial Policy of 24 July 1991.

3. Explain liberalisation, privatisation and globalisation. Liberalisation is the removal of licences, permits and quantitative controls on domestic economic activity, so that the decision to produce, to expand or to enter an industry is taken by the enterprise rather than by an authority. Privatisation is the reduction of the role of the public sector, whether by selling shares in public undertakings, by opening industries previously reserved to the State, or by transferring management to private hands. Globalisation is the integration of the domestic economy with the rest of the world through trade in goods and services, flows of capital and technology, and to a limited extent the movement of people.

4. In what sense is the phase since about 2014 different from both earlier phases? It does not restore licensing or public sector reservation, so it is not a return to phase one; but neither does it treat withdrawal of the State as the objective, so it is not simply a continuation of phase two. The State's role has changed in kind: it builds infrastructure directly, with capital spending rising from about 12.5 per cent of central government expenditure in FY20 to 22.6 per cent in FY25 on provisional actuals; it builds digital public infrastructure in identity, payments and data on which private firms then operate; it pays subsidies directly into bank accounts instead of supplying goods cheaply; it has unified indirect taxation through the goods and services tax; and it uses production linked incentives, which is industrial policy conducted by subsidy rather than by permission.

5. "Planning ended in 1991." Is this correct? No. The reforms of 1991 dismantled industrial licensing and import controls, but the Planning Commission continued to function and Five Year Plans continued to be drawn up, the last being the Twelfth Plan. The Commission was abolished and replaced by NITI Aayog only on 1 January 2015, by a Cabinet Secretariat Resolution, and the change was one of function as much as of name: NITI Aayog advises and evaluates but makes no financial allocations, which the Planning Commission did. What ended in 1991 was the licensing of private industry, not planning.

6. Give one achievement and one failure of each of the first two phases. Phase one built a diversified industrial base, including heavy industry, power and fertiliser capacity that no private investor would have financed at the time, and achieved self sufficiency in foodgrains through the Green Revolution; but it produced slow growth, persistent shortages and industries with no incentive to reduce cost or improve quality, ending in the balance of payments crisis of 1991. Phase two raised the growth rate substantially, widened consumer choice, attracted foreign investment and made Indian firms internationally competitive in several sectors; but employment did not expand in proportion to output, manufacturing did not grow as expected, and inequality between persons and between States widened.