Reversal of Fortune: the Geography Hypothesis
• Early, ‘crude’ version: Montesquieu (1689-1755)— people in tropical climates are lazy, lack inquisitiveness, are
not hard-working or innovative (Also, see comments on India and China, for example, in recently published travel
diaries of Albert Einstein)
• Contemporary, ‘sophisticated’ version: Jeffery Sachs— tropical diseases, particularly malaria, have adverse
consequences for health and therefore labor productivity and tropical soils do not allow for productive agriculture.
• No empirical evidence: e.g. North and South Korea today, North and South America in the past.
Reversal of Fortunes: the Culture Hypothesis
• Early version: Max Weber—Protestant reformation in Europe and development of capitalism; Hinduism,
Buddhism, Confucianism etc. not conducive to capitalism.
• Modern (non-articulated, because ‘politically inappropriate’, but widely shared beliefs) : ‘Africans are poor
because they lack a good work ethic, still believe in witchcraft and magic’, or ‘Latin America will never be rich
because its people are intrinsically profligate and impecunious’.
• Counter-arguments: No empirical evidence
• Also, though slow changing, culture must have been profoundly modified by the colonial encounter.
Reversal of Fortunes: the Institutions Hypothesis
• European Colonization: A Natural Experiment
• Colonization transformed many of the institutions in the colonies. Europeans imposed different sets of institutions
in different colonies.
• The relatively densely settled and highly urbanized colonies ended up with worse (or ‘extractive’) institutions,
while sparsely settled and non-urbanized areas received an influx of European migrants and developed institutions
protecting property rights and other economic and civil rights.
What are good institutions?
a) Enforcement of property rights for a broad cross section of society, so that people have incentives to invest
b) Constraints on the actions of elites, politicians, and other powerful groups, so that these people cannot create a
highly uneven playing field
c) Some degree of equal opportunity for broad segments of society, so that individuals can make investments,
especially in human capital
Why did bad institutions persist after decolonization?
• The difficulty of institutional reform lie in the fact that any major change creates winners and losers, and the
potential losers are often powerful enough to resist change.
• Distribution of political power determines the evolution of institutions.
• Political institutions allocate de jure power and those who hold power tend to influence evolution of political
institutions in a way that maintain their political power.
• This explains persistence of political institutions.
How can Institutions change
Institutional change will happen either
a) when groups that favor change become powerful enough to impose it on the potential losers,
b) when societies can strike a bargain with potential losers so as to credibly compensate them after the change takes
place or, perhaps, shield them from the most adverse consequences of these changes. -E.g. Land reforms
Stages of Colonization: 1757- 1900
• 1 st stage (second half of the 18th century) : Marked by direct plunder and the East India Company’s monopoly
trade, functioning through the ‘investment’ of surplus land revenues in the purchase of, at low prices, of Indian
finished goods for export to England and Europe
• 2nd Stage (first half of the 19th century): Industrial Revolution in England dramatically changes the pattern of
trade, transforming India from a producer and exporter of manufactured goods to a producer of raw materials for
English factories. Deindustrialization. Opium trade facilitates realization of tribute from India.
• 3 rd stage (second half of the 19th century): British capital pours in. Railways, commercialization of agriculture
and further development of India as the source of raw materials and the market for English manufactured goods
(capital goods as well as consumer goods).
Deindustrialization
• Weaving and spinning industry were hit by British competition as Indian weavers first lost their export market and
then domestic market
• Urban artisans were hit because of decline of traditional aristocratic class and the export market. Imperial factories
(Karkhanas) declined.
• The new ruling class was the British and the Indian elite—landlords, professionals, who imitated the British
lifestyle—who imported luxury goods from England. Thus decline of urban demand for Indian manufactures.
• Absolute decline in urban population in Eastern India (Patna, Dhaka, Murshidabad etc.), except Calcutta which,
being the capital of British India, grew fast.
• Traditional ship-building industry goes down.
• Alongside the cotton goods, English exports to India of iron goods, cutlery, guns, glass, and 'machinery', increased
enormously throughout the nineteenth century
• Artisans and weavers in the rural hinterland were hurt much later, after the penetration by railways.
Permanent Settlement: zamindari land Revenue Settlement, 1793
• Zamindars and jagirdars were declared proprietors of the land with fixed revenue obligations to the state (90% of
rent). If improvements were made and the rent increased, the benefits will go to the zamindars.
• Peasants became tenant farmers, rents were collected by a series of intermediaries, inflating the rent burden on the
peasants.
• The British thought that the zamindars would regenerate agriculture, preserve local custom and protect rural life.
• Covered present-day Uttar Pradesh (except Oudh and Agra), Bihar, West Bengal, most of Orissa, Rajashthan,
except Jaipur and Jodhpur)--57% of the total area cultivated.
Land Revenue and the ‘tribute’
• Entire land revenue was treated as Gross Profits of the Company. Deduct expenses necessary for maintaining
government and army, law and order and get Net Profits.
• The net profits were then used for the purchase of Indian commodities— ‘Investments’
• Monopoly powers; buy cheap and sell dear. Enlargement of Profit before the ‘tribute’ was received in England.
• There was not much demand for British goods in India. Earlier Britain had to pay for Indian imports with gold
and other precious metals.
• After EIC got land revenue, outflow of gold and other precious metals from Britain to India goes down as Britain
didn’t need to pay for the imports from India.
• The main form of this tribute was the export surplus of India. Imports from India as a share of British imports
increased from 12 % in 1750-51 to 24% in 1797-98.
• British exports to India increased from 6.4 % to 9 %.
• The colonizers were not looking for markets for their goods. They were looking for colonial commodities which
had markets worldwide.
Two-fold effect of the tribute:
a) Decline in urban employment of troops, retainers, craftsmen in traditional luxury trades supported by previous
ruling class and nobility
b) Disruption of Indian trade—between East and West India— e.g. Gujarat silk manufacturers were deprived of
Bengal Silk much of which was exported by EIC.
Consequences of the Permanent Settlement System
• Instead, a class of absentee landlords was created employing a series of intermediaries that increased the rent
burden on peasants who have become tenant farmers.
• The zamindars found different ways of levying taxes and other obligatory payments on the peasants.
• The political structure was altered forever with the zamindars enjoying unchecked power over peasants.
Land Revenue Systems under the British: Ryotwari System
• Individual cultivators (ryots) became proprietors of their land with the right to sublet, mortgage and sell land.
• Short-period settlement of rent and the rent obligation could be changed by the government.
• Land became a transferable property.
• Covered Maharashtra, Karnataka, Andhra Pradesh, Tamil Nadu, Kerala, most of MP, Assam, Jaipur, Jodhpur—
38% of total cultivated area.
Land Revenue Systems under the British: Mahalwari System
• Revenue settlement was made with entire villages as collective units.
• Peasant farmers shared the total revenue obligation (83% of gross produce to begin with, later decreased) in
proportion to their respective holdings.
• Covered Punjab (in both present-day India and Pakistan), Haryana, parts of MP and Odisha, Oudh and Agra. 5%
of cultivated area.
Consequences of Ryotwari and Mahalwari Systems
• Land alienation and polarization of society into landlords and rich peasants on the one hand and tenants and
agricultural laborers on the other hand.
• Land markets develop.
• Alienation of land due to very high initial assessment of land revenue.
• The pressure of land revenue continued to be very high till the mid-19th century, after which land revenue
declined in importance as the source of government revenue.
• Emergence of highly unequal distribution of rural assets. In 1924-25, 86% of cultivated land in Bombay was held
by 12% of cultivators.
• In Punjab in 1939, 38% of cultivated land was held by 2 % of cultivators. (The inequality of land distribution was
higher in zamindari areas)
Commercialization of Agriculture
• Drain from India to England--Since India was deindustrialized, agricultural commodities had to be marketed and
exported to meet this drain.
• India supplied agricultural raw materials and food crops to industrializing nations.
• First half of the 19th century: Indigo, silk, opium, sugarcane. Production of these crops was oriented towards
international markets.
• In the second half of the 19th century, principal cash crops: cotton, wheat, sugarcane, jute and tea.
• Britain was the ‘factory of the world’ by mid-19th century. India supplied agricultural raw materials and food
crops to industrializing nations, importantly Britain.
Commercialization of Agriculture: ‘Normal’ or ‘Forced’ ?
Commercialization is often interpreted as a sign of transition from pre-capitalism to capitalism. Was such transition
taking place in India in the colonial period?
Agricultural commercialization was ‘forced’ and ‘artificial’. Peasantry was ‘dependent’ and ‘subordinate’.
A ‘normal’ process of commercialization of agriculture: increased marketed surplus from increased production
over self-consumption requirements of the peasants. Sign of high productivity.
An ‘artificial’ process of commercialization of agriculture: Forced to sell a high proportion of their output to
meet immediate cash requirements, Sign of low productivity.
Land Reforms in Independent India
• Abolition of Intermediaries
• Tenancy Reforms: Reduction of Rents, security of tenure, ownership rights of tenants
• Ceiling on land holdings and distribution of surplus land
• Consolidation of holdings
It is generally agreed that abolition of intermediaries has been relatively successful. With respect to the remaining
land reforms, the result has been mixed. Landowners resisted the implementation of these reforms by directly using
their political clout and also by using various methods of evasion and coercion, which included registering their
own land under names of different relatives to bypass the ceiling, and shuffling tenants around different plots of
land, so that they would not acquire incumbency rights as stipulated in the tenancy law.
The Third Phase of Colonization: The Second Half of the 19th Century
Crown Rule
• Under the new regime the emphasis shifted from the levy of direct tribute through land revenue to the exploitation
of India as a market and as a source of raw materials and a destination for British capital.
• Zamindars were transformed into true landlords and the political ally of the British rulers who were scared by the
Sepoy Mutiny.
• About the middle of the nineteenth century, factory production was extended to all industries in Britain. The
search for new profitable outlets for British capital began.
Infrastructure and Institutions
Existing infrastructure constrained business and effective governance. Lesson of 1857—Need for tighter Imperialist
control, free movement of raw materials from India, imported manufactured products from Britain and British
troops.
• Abolition of transit and town duties between 1836 and 1844.
• Assault on Thugees and Pindaris
• Unification of currency –The company rupee was declared legal tender throughout he Empire
• Homogenization of weights and measures was less successful.
• Introduction of Railways in 1854
• Modern British Education
• Company Laws—1850.
• Limited Liability-1857
The ‘Tribute’ in the Third Phase of Colonization (1857-1900)
• The burden of EIC’s London establishment and of dividends to its shareholders was replaced after 1858 by the
costs of Secretary of State’s India Office.
• “Home charges” also included pensions to British Indian officials and army officers, military and other stores
purchased in England, costs of army training, transport and campaigns outside India but charged on Indian
finances and the guaranteed interest on railways.
European Agency Houses
• European private traders adopted a business organization called agency houses, so called because agency houses
a) acted as business agents for others against a fee and b) agent of a firm in London
• Agency houses participated in China trade (opium) and indigo trade.
• Agency firms needed Indians as agents—known as banians—to assist them in a myriad ways. The banian was the
centre of the operation and received a percentage of sale proceeds.
• Indians have their first encounter with modern business forms and ideas ( as they first developed in Europe) as
banians and agents of the European Agency firms.
The entry of Marwaris in Industries
• The Marwaris had kinsmen scattered throughout India which helped them in networking; they have been present
in Bengal for long.
• They dealt as brokers, banians, sub-contractors, agents to Europeans, making themselves almost indispensable to
trade practices.
• They operated in trading of opium, spices, jute, etc.
• They amassed capital in trade, finance and speculation (using instruments like futures and options)
• Marwaris moved from trade into industry in 2 ways after WWI—
i) The establishment of new jute mills and collieries
ii) Steady purchases of shares in companies controlled by European managing agencies, to a point where Marwaris
could first force their way into the boardrooms and then take over the firms
• The Marwaris provided the British with raw jute, short term credit, and long-term loans.
• The British did need mediators in trade and finance, but did not welcome the Marwaris.
• Scottish arrogance and consequent business hostility.
The Western Scenario in the first half of the 19th century
• Bombay, coming later under the British rule, was spared the worst excesses of the early decades of the Company
rule.
• Also, the Bombay Presidency being a chronically revenue-deficit area, depended on remittances from the Bengal
Presidency, which made the EIC dependent on merchants and bankers.
• Bombay replaced Surat by the middle of the 18th century as the main port on the West.
• The Europeans made their base in Bombay and drew Indian merchants and shipbuilders, particularly Parsis, from
Surat area.
The Parsis of Bombay
• The relationship between the Parsis and the British in Bombay was a continuation of their positive relationship in
Surat.
• As the Parsis in Surat were economically independent and prosperous, the British had to create an attractive
economic environment to persuade them to migrate to Bombay.
• The Parsi community had a unique relationship with the British. They were more ‘Westernized’ than the other
communities. They were loyal to the British during the Mutiny in 1857.
Opium Trade
• Since 1770s the fortunes of Indian merchants were linked to the China trade. Opened up opportunities for
merchants in Ahmedabad, Surat, Broach, Cambay, Baroda, Bombay.
• In Western India, opium trade remained a clandestine operation. Malwa opium was grown in regions within a
princely state. Thus its supply was controlled by indigenous merchants; private Indian merchants shipped it to
China and earned profits. EIC couldn’t stop this and hence had to legalize opium trade against export permits.
• In contrast, in Bengal, production and trade of opium was tightly controlled by the Company.
Parsi industrialists
• The pioneers in the Bombay textile industry came almost entirely from among the Parsi traders, shippers and
financiers of Bombay
• The Parsis started their careers as traders (in opium and raw cotton). Then, some became formal brokers to British
trading houses and, finally, diversified into the cotton industry.
• Parsi tradition was to send their sons to work in the British firms, where they could learn on the job. The European
businesses in Bombay warmly welcomed these trainees.
• Yet, others—Hindus, Muslims, and Jains—also became increasingly important in this period.
Difference between Western and Eastern India
• Bombay benefitted from the large class of merchants from Gujarat, with a larger ethnic and communal diversity—
Hindus, Parsis, Muslims, Jains etc.—in Bombay business circle.
• In the East, business was entirely dominated by Europeans, until challenged by the Marwaris in a bitter business
fight colored by racism. Bombay benefited from a “more dynamic atmosphere of emulation and competition” and
“less racial and communal strife”.
• The Bombay industries also showed greater flexibility to adopt innovations and tackle changing market
conditions, including orienting themselves towards the domestic market.
Ahmedabad
• After 1818, the British officially began to rule Ahmedabad. but the old city preserved its traditional structure of
guilds and castes as well as its commercial outlook.
• The Indians built Ahmedabad. British did not have a major role in commercial life of Ahmedabad.
• In the early 18th century, many weavers, traders, and artisans fled the city because of the war between the
Mughals and Marathas.
• Stable administration by the British brought back indigenous traders and weavers who settled there again in the
nineteenth century.
Mode of financing Ahmedabad textile mills
• The occupational background of the textile industrialists in Ahmedabad differed from that of their counterparts in
Bombay.
• None of them had any experience in a British trading firm or had ever worked as a broker for a European trading
company. Some of them profited handsomely from cotton trade during American Civil War. They mostly came
from banking background. Ranchhodlal Chhotalal, who set up the first mill in Ahmedabad, was a Hindu civil
servant.
• Banks and shareholders financed Bombay’s mills to a greater extent than in Ahmedabad. Ahmedabad mills were
financed by small individual deposits for a fixed interest rate.
Attitude of colonial state
• In Calcutta, Indian businessmen were excluded from the upper ranks of the business hierarchy and faced British
racism and hostility.
• In Bombay partnerships between Europeans and Parsis were a common feature and there was much less hostility
and discrimination.
• In Ahmedabad, the colonial state displayed neither a positive nor a negative attitude towards Indian businesses.
Minority status and religious background of pioneer industrialists
• Marwaris in Calcutta: They were Hindus and Jains from Marwar; the British considered them insiders but the
Bengalis considered them outsiders.
• Parsis in Bombay: Initially, they were a majority, later they became a minority since 1850s.
• Hindus in Ahmedabad: Majority community and insiders.
Rise of Indian Industries and Conflict with British Industrial Interests
• With the rise of the cotton textile mills in Western India, there is conflict with firms in England, inviting
Manchester's hostility .
• All import duties on textile goods were banished in 1882. Opposed by Indians.
• Factory Acts of 1892 protecting workers' welfare (imposed at the insistence of Lancashire mill owners)—
particularly women and children. Faced opposition from Indian industrialists.
• In 1894, an import duty was imposed on imports into India and as a result, countervailing excise duty was
imposed on production of textile goods in India to offset the duty on imports. —
• Birth of nationalist politics. Indian National Congress formed in 1885. Nationalist call for state intervention to
develop industries in India. —
• “Drain of Wealth” Critique (extraction of tribute as “Home Charges” ) by Dadabhai Naoroji, M.G. Ranade,
R.C.Dutt etc.
Phases of Industrialization in the colonial period
• First Phase: 1850-1914—Emergence of cotton industry in Western India, i.e. Bombay and Ahmedabad, and jute
industry in Eastern India, i.e. Calcutta. Critique of Economic policies of Colonial state. Swadeshi and Indian
industries.
• Second Phase: World War I—Excess Demand and Supply constraints for Indian industries. Criticism that the govt.
was hostile to indigenous entrepreneurs.
• Third Phase: Interwar Period 1920-1939—Government support for Indian industries; Fiscal Autonomy
Convention of 1919 accepted India's right to pursue an independent tariff policy. In Indian Industrial Commission
(1916-18), Govt. accepted responsibility for encouraging industry; Indian Fiscal Commission (1921-22) agreed to
time-bound Protective Tariff selectively to Indian industries -> maturation and diversification of Indian industries
-> European share of total capital employed in Indian companies fell from 72% in 1918 to 40 % in 1939
• Fourth Phase: World War II—I—Excess Demand and Supply constraints for Indian industries; depreciation of
capital equipment and build-up of sterling reserves.
Bombay Plan, 1944
• Put forward by leading Indian industrialists as a vision document for India’s planned industrialization.
• Wide publicity
• Immediately endorsed by FICCI.
• Widely influential
• “. . . In order to prevent the inequitable distribution of the burden between different classes which this method of
financing will involve, practically every aspect of economic life will have to be so rigorously controlled by
government that individual liberty and freedom of enterprise will suffer a temporary eclipse.” (Bombay Plan)
• 15-year horizon.
• Similarity with first three 5-year Plans in independent India.
Economic Context of Bombay Plan: World War II
• Qualitative Effect same as WWI--Excess demand and supply constraints.
• India's dependence on imports of capital goods and machinery meant that they could not reinvest their profits and
could not expand. Their machines were also depreciated due to over-work.
• The building-up of “Sterling Balances” and the “Dollar Pool” of more than Rs. 1500 crores in 1947 (estimated at
seventeen times the annual revenue of the Government of India and one fifth of Britain’s gross national product in
1947) .
• Indian industrialists try to compete with European firms to access this foreign exchange reserve.
The Political Context of Bombay Plan
• Private business did not enjoy a favourable public opinion in India and its esteem particularly plummeted during
the War because the Indian public had a negative image of private business.
• Private business also thought that Quit India Movement of 1942 might go out of control of Congress and turn
against Indian private business as well.
• Even if that did not happen, independent India’s government might be confronted with strong and violent
demands for income redistribution, and therefore forced into adopting populist policies not suited to the country’s
long run interest
Industrial Policy of the Government of India, 1945
• Government of India acknowledged the influence of the Bombay Plan.
• Central control over twenty categories of basic industries, (Iron and Steel, Machines, Plants and Tools, Electricals,
Chemicals, Transport, Cement etc. and some consumer goods industries like Textiles, Sugar, Automobiles, etc).
• Nationalization of other ‘basic industries of national importance’ in which adequate private capital was not
forthcoming (air-craft, automobiles and tractors, chemical machinery, machine tools etc.)
• In some cases, (ship building, locomotives and boilers etc.) both govt. and private industries.
• Overall industrial development would be controlled, through industrial licensing.
• To allow freedom to small industrial enterprises, any new industry beyond a certain capital value would require
licence from the Government to operate. This, the Government observed, would enable them to distribute
industries all over the country and check over-concentration in certain places.
Indian Policy 1948: Mixed Economy Framework
(a) Exclusive State Monopoly: arms and ammunition, atomic energy, railways.
(b) State Monopoly for New Industries: coal, iron and steel, aircraft manufacture, ship building, manufacture of
telephone, telegraphs and wireless (apparatus (excluding radio receiving sets) and mineral oils. New
undertakings in this category could henceforth be undertaken only by the State.
(c) State Regulation: -machine tools, chemicals, fertilizers, nonferrous metals, rubber manufactures, cement, paper,
newsprint, automobiles, electric engineering etc. which the Central Government would feel necessary to plan
and regulate.
(d) Unregulated Private Enterprise :industries in this category were left open to the private sector, individual as well
as cooperative.
(e) However, provision for exceptions in the “national interest”.
Industrial Policy Framework
• Industrial Development and Regulation Act, 1951—license to set up new and expand existing enterprises to
a) Check concentration b) To ensure investment according to plan priorities c) Regional balance
• Import and tariff policies: restrict imports of consumer goods and allow import of machinery and plant equipment
for priority sector; accent on import substitution and infant industry protection.
• Govt. set up Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India
(ICICI), Industrial Development Bank of India (IDBI), Industrial Refinance Corporation of India (IFCI) etc. for
long-term finance to industries.
The three assumptions underlying the planning process:
• the basic constraint on development was the deficiency of capital
• Industrialization provided the means for surplus labour to be productively employed
• Government needed to control investment because if market forces operated concentration of investment (both
location and holding) would continue and investment would flow to non-essential sectors
The Industries (Development & Regulation) Act, 1951
• The most complex and comprehensive system of control and regulation of private sector enterprise devised
worldwide
• Objectives:
1. regulation of investments according to plan priorities and targets
2. prevention of concentration of holding in the private sector o balanced industrial development to reduce
disparities in levels of development
3. protection and encouragement of small-scale industries .
• Delegated vast powers to the bureaucracy
• All existing industries had to register
• Licenses were required for new investments, capacity addition or overproduction
• Industries were subject to regulation that included the power to: o investigate the operations of a firm o assume
management control if necessary o control supply, distribution and prices of products .
• The Act initially covered 42 industries and 150 articles of manufacture
• The list was expanded in 1956 to include an additional 26 industries and by the midsixties it covered almost all
industries
Taxation Policy - Objectives
• produce a sizeable addition to public revenue
• provide incentives for larger earnings and more savings
• restrain consumption over a fairly wide field so as to keep in check domestic inflationary pressures and release
resources required for investment
• initiate such changes in the tax structure as would make tax yields progressively more responsive to increased
income and facilitate an orderly development of the economy with due regard to the social objectives we have
adopted
• Taxation was related not just to economic policy but to social strategy as well
• Income tax rates were hiked both to collect additional revenue and reduce disparities in income
• New Taxes were introduced – Estate Duty (1953) – Capital Gains Tax (1956) – Wealth Tax (1957) – Gift Tax
(1958)
Why was growth in the 50s not sustained?
• Rapid growth in the 50s was the result of unique circumstances
• Huge increases in budgetary support for public sector investment increased output
• Good monsoons in 1953-54 and 1954-55 which increased agricultural production, reduced inflation and generated
demand for manufactured goods
• Large sterling balances accumulated during the war years provided capital necessary for imports
Problems of the licensing system
1. Delays in clearances • Large number of applications, inadequate infrastructure for review
2. Sequential consideration of applications • Designed to prevent unnecessary investment, but restricted competition
3. Absence of criteria for selection • Arbitrary decisions, opportunities for corruption
Export Pessimism and its Impact on Policy
• The emphasis in planning was on investment in the public sector, particularly heavy industry which was seen as
the key to growth
• ‘Export pessimism’ meant that an export led model was seen as unworkable
• India had to become ‘self-reliant’ through import substitution industrialization, made viable by high trade barriers
• Self-reliance also meant development of diversified indigenous industrial capabilities that would eventually create
a base for exports
• The policy of import substitution led to an excessive pre-occupation with self-reliance without regard to efficiency
or economies of scale
• Licensing constrained private investment (except by large firms) and created inefficiencies in the economy
AICC recommendations
• Social control over banking
• Nationalization of general insurance
• Implementation of the Monopolies Commission Report
• Abolition of privy purses
The MRTP Act
• The Act was passed in 1969 and came into effect from May 1970
• Objectives
– Prevention concentration of power to common detriment
– Control of monopolies
– Prohibition of monopolistic and restrictive trade practices
• The Act applied only to private sector firms, not government undertakings .
• The Act was implemented by the Monopolies & Restrictive Trade Practices Commission
• The Commission divided Indian Industry, outside the small and medium-scale sector into three categories:
1. Large Industrial Houses (assets in excess of 20 crores)
2. Dominant Undertakings (market share of 33 percent)
3. Foreign firms and subsidiaries .
• All firms which came under the purview of the Act had to register with the Department of Company Affairs
(DCA) and also secure approval from the MRTP Commission for additional investment
Foreign Exchange Regulation Act
• Designed to impose additional restrictions on foreign investment in India
• Foreign firms had to divest foreign shareholding to 40% and become an Indian company under the Companies Act
and would be treated largely similar to domestic firms
• For higher holdings restrictions applied
• Restrictions included limitations on profit transfer and acquisition of property .
• The maximum permissible equity holding was 74 percent
• Exceptions being made only in rare cases where a firm was engaged in ‘core activities, used sophisticated
technology or met specified export commitments
The impact of policy changes
• The changes in government policy ensured greater political stability, but it had implications for economic policy
• Mrs.Gandhi returned to power in 1971 with a strong mandate after campaigning with an emphasis on ‘poverty
alleviation’
• There was an increased emphasis on publicsector investments for creating employment
• Economic strategy shifted from emphasizing growth to a more direct attack on poverty
• This involved higher spending on poverty alleviation programmes
• Higher increases in public investment without internal liberalization meant that efficiency of investment remained
a problem for Indian industry throughout the 70s
• The 1971 war, the 1973 oil price shock, and low industrial growth meant that growth rates averaged less than 3%
during the decade and per-capita growth GDP growth was almost stagnant
The ‘Green Revolution’ in Agriculture
• There was more targeted investments in agriculture to reduce dependence on food aid
• Achieving self-sufficiency in food was the great success story of the seventies
• Investments in irrigation and extension services increased yields and made output less dependent on monsoon
• The green revolution involved high-yielding seeds, chemical fertilizers and pesticides – and lots of water supplied
through major and minor irrigation projects
Agriculture and Poverty Reduction
• While agricultural production increased it did not have a significant impact on poverty
• Returns from increasing yields went primarily to larger landowners, despite attempts at land reform
• Land reform is often unsuccessful in the absence of complementary policy reforms and these were absent in India
• Land reforms, though enacted was rarely effective on the ground for three reasons:
– Political power of the landowners which made reform ineffective (alienation of land and bonded labour)
– Inability of peasants to mobilize
– Poor financial support systems which led to further concentration of holding
• Two other means by which agricultural surpluses could have been redistributed were not successful in India
• These were taxation of agriculture and high minimum wages in agriculture .
• Agricultural growth was also spatially concentrated in areas with well developed irrigation infrastructure,
primarily select states and districts in the north-west, east and south (Spread of Irrigation)
• The Food Corporation of India began to procure output at minimum support prices which provided an assured
market for produce for large farmers
• Income disparities in agriculture, however, continued and this made government intervention through poverty
alleviation programmes essential
Industry
• Capital for investment and efficiency of investments continued to be a problem for industry
• Public sector investments did not generate significant returns and capital was scarce because of increased revenue
expenditure
• For the private sector the additional controls were restrictive
• But many firms learned to adjust, and even benefit from additional controls, just as they had in the 50s when
IDRA was implemented
• The process of adjustment
• Violation of capacity restriction
– 20 percent of licenses operated in excess of licensed capacity
– 4 percent at double licensed capacity
• Creation of unlicensed capacity
– Investments were made without obtaining licenses
– Government often issued licenses when unlicensed capacity was discovered .
• Non-operation or under utilization of licenses
– Under utilization to create scarcity and drive up prices
– Non-operation to prevent rivals for gaining additional licenses
– Lobbying to prevent punitive action
• Deliberate flouting of government regulations
– Rules were often broken as part of deliberate policy since it was difficult, sometimes impossible, to adhere
to all rules
Government as a risk absorption mechanism
• Clauses on converting loans to equity were sometimes not implemented in the manner intended
• When units were profitable, industry lobbied to keep them as loans
• When units became sick, the loans were converted to equity prior to takeover by the government
• This further increased expenditure on the public-sector
Structural Evolution of Private Industry
• In 1976 the top 20 business houses controlled nearly two-thirds of total productive capital in the private corporate
sector
• Concentration did not decrease significantly despite the MRTP Act.
• Sales of the top 20 companies as percentage of sales in the private corporate sector increased from 61% to 87%
during the 1970s .
• While concentration remained, there were changes at the top of the list
• The Tata and Birla groups remained dominant with 40% of the sales of the top 20
• However, some firms, less dominant earlier, and some new ones, began to grow under conditions of increased
controls
• The fastest growing firms were newer entrants to the list, like the Modi and Escorts groups and later Reliance
Positive Aspects of Planned Development
• Created a wide industrial base within a short period of time which helped private industry after liberalization
• The need for skilled manpower for the public sector prompted a huge expansion in higher education, especially
technical education
• Created a large ‘aspirational’ middle class
Political Impact of Low Growth
• Low growth in the 70s and the failure to keep election promises to remove poverty had a political impact
• Mrs.Gandhi, in the face of mounting opposition tried to assert her power by declaring an Emergency in June 1975
• However, in elections held in 1977she is removed from office and an opposition coalition takes power with
Morarji Desai as the PM
• The coalition is unstable and it collapses in 1979
Reasons for Liberalization
1. The disillusionment with socialism • The failure of controls led to a change in attitude towards the private sector
during the seventies • It became clear, even to die-hard socialists that economic policy was not having the desired
effects
2. The experience of South East Asia and Latin America • The export-led growth model and borrowing for
investment was seen as more successful
3. Support for market friendly policies among the middle classes • Impatient with slow growth and also more
assertive • Now benefiting from private sector profits
4. Pressure from international agencies • The need to secure funding from the IMF led to changes in policy
Mrs. Gandhi’s views on economic policy
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Mrs.Gandhi’s views on economic policy changed during her second term in office
Policy became more pragmatic and there was less emphasis on socialism in economic policy making
Though not publicly acknowledged, the process of liberalization began during her second term in office
Relaxation of imports of manufactured goods – Tariff reductions and reduction of quantitative restrictions
Price de-control in select sectors – Partial de-control of steel and cement prices
Grant of licenses without reference to Plan projections of demand – Increased emphasis on efficiency of
investment Liberalization Measures .
• Implementation of L.K.Jha Commission recommendations – 20 industries were placed under automatic licensing
However, licensing restrictions were not lifted and Mrs.Gandhi was careful not to be too closely identified with
liberalization
Liberalization under Rajiv Gandhi
• Attempt to shift from a state-controlled, import substitution model to a more liberal environment
• The 1985-86 Budget
• Reduction of personal and corporate taxes
• Top rate reduced to 50% and slabs reduced from 8 to 4
• Corporate taxes reduced from 60% to 50%
• Abolition of Estate Duty
• Liberalization of imports, especially of electronic and hi-technology products by reduction of import duties
• De-licensing of 25 industries, primarily in electronics and telecommunications equipment manufacture
Changes to MRTP Act and FERA
• Asset limit for MRTP companies raised from 20 crores to 100 crores
• In hi-tech industries MRTP firms could invest without MRTP approvals
• FERA companies were also allowed to invest in technology-intensive sectors under conditions similar to domestic
firms
• In de-licensed sectors they were allowed to invest without the need for additional licenses from the government
The Nature of Liberalization
• While changes in policy were significant, there was no fundamental shift from the past
• Certain sectors where government control was ineffective was de-licensed
• In other areas de-licensing was selective
• There was no move to fundamentally change the system by abolishing licensing
Economic Performance in the 80s
• The economy performed better in the 80s compared to the sixties and the seventies GDP grew by 5.8 percent and
industry by 6.5% percent on average per during the decade
• This was in comparison to growth of 2.9% between 1965 and 1979
• Investment was also more efficient in the 80s
• However, like the fifties, higher growth was largely the outcome of factors that were unsustainable, especially in
times of crisis
• Exports did not grow significantly in the first half of the 80s because industry was not yet competitive
• However, growth remained high because of positive external factors which made increased imports possible
• The rapid increase in domestic oil production because of new oil discoveries meant that outflow of FE for oil
imports was relatively less
• There was also an increase in remittances from expatriate workers .
• Concessional external funding, especially from the World Bank and the IMF kept debt service obligations down in
the first half of the decade
• In the second half of the decade though exports increased it could not cover for increasing imports and
competitiveness remained a problem for industry
Problems of reforming a protected economy
• Impact on competitiveness of protected industries
• Impact on the public sector
• Proper sequencing of liberalization measures – dealing with pressures from the private corporate sector
• Short term import surge, uncertain longterm competitiveness
Problems of reform in a democracy
• Building up a constituency for reform among
– Political Establishment
– Bureaucracy
– Special interest groups
• Dealing with the electoral impact of ‘reform pain’ in affected sectors
Economic Strategy since 1985
• Rajiv Gandhi’s economic strategy focused on three aspects of reform
• Encouraging capital imports to upgrade technology – Elimination of quantitative controls on import of industrial
machinery and cuts in tariffs
• Modest industrial deregulation to increase investment – reduction in number of industries subject to licensing \
• Rationalization of tax system in order to increase revenue
The Reasons for High Growth
• Relaxation of controls in some sectors of industry which increased investment
• Increased availability of funds for consumption and investment because of reductions in taxes
• Increased availability of cheaper imported inputs for domestic production
• Private capital inflows and borrowing abroad
Large Fiscal Deficits
• Reforms were carried out within the constraints of a democratic environment
• There was an emphasis on carrying out reforms that directly and immediately benefited some sections
• The harder reforms that might have alienated electoral constituencies, but could have resulted in better quality
growth, were put off .
• Reduction in taxation was popular, but there was no emphasis on preventing tax evasion
• Tax collection did not go up significantly and this increased the fiscal deficit
• Revenue expenditure increased during the eighties both because of a hike in salaries of government employees
and, later in the eighties because of increase in subsidies and liberal grant of unsecured loans
Competitiveness in Indian Industry
• Competitiveness continued to be a problem for Indian industry Industry could nor respond as quickly as the
government expected to external competition
• Private industry tried to get continued protection arguing that the government was liberalizing too quickly and
tried to stall liberalization measures .
• Labour reforms were not implemented and so even when domestic industry tried to become competitive by
downsizing they found that labour regulations stood in their way
• Though there was an emphasis on efficiency, there were no moves to divest public sector units or to close down
unviable units
• Investment increased in high-technology, liberalized sectors, but not enough to increase competitiveness, or
exports, significantly .
• Since reform was partial there was no significant increase in export competitiveness in Indian industry
• Exports did not rise sufficiently to cover for increased outflow of funds resulting from liberalization of imports
NRIs as sources of capital
• The government liberalized investment rules and allowed NRIs to invest in Indian capital market, provided
holdings did not exceed 3% of shares in a firm
• They were also given attractive returns on bank deposits and assurance of repayment in a convertible foreign
currency
• Deposits by NRIs in Indian banks increased as returns were higher than investments abroad
Reasons for short-term borrowing
• NRI deposits were only one source of foreign exchange
• The second source was short-term commercial borrowing abroad
• Borrowing was necessitated by the fact that exports did not rise to keep up with increasing imports
• The government had the option to go to the IMF for funding .
• However, the liberalization measures were unpopular within the Congress party and in rural areas and the
government was worried about the political implications of going to the IMF
• A politically more feasible option was short-term commercial borrowing abroad which was available
• However, the only loans commercially available were short term loans .
• There was increased availability of loans from international banks because of – Higher returns on loans to
developing countries – The Latin American debt crisis and reduction in lending to traditional borrowers
• The banks, however, were concerned about risks in lending International banks were reluctant to give mediumterm or long-term loans and gave only short term loans to developing countries
Rapid rise in external debt
• External debt doubled from US $ 35 billion in 1984-85 to $ 69 billion in 1990-91
• NRI deposits rose from $ 3 billion in 1984- 85 to $10.5 billion in 1990-91
• Short term external debt grew sharply to $ 6 billion
• The increasing reliance on external shortterm debts made the country vulnerable to external shocks
Immediate Causes of the Crisis
• The Iraqi invasion of Kuwait in August 1990 and its financial impact
• Political Instability
• Downgrade by international credit-rating agencies
• Repayment of short term debt and the decline of foreign reserves
The Impact of the Gulf War
• The price of oil nearly doubled Value of petroleum imports increased from US $ 3.5 billion in 1989-90 to $ 5.7
billion in 1990-91
• Workers remittances from the Gulf were sharply reduced
• There was a loss of some export markets in the Gulf region .
• Fearing rupee depreciation import payments were brought forward by firms and export proceeds held abroad
leading to negative impact on foreign reserves
• NRI inflows turned to outflows as NRIs, fearing a moratorium on payments in denominated currencies, withdrew
deposits and took funds out of the country
The Political Crisis
• The Congress Party lost the election in November 1989 and though it emerged as the largest single party, it
refused to form a coalition government
• The second largest party the Janata Dal formed a non-Congress Government under V.P.Singh
• The V.P.Singh government fell apart in December 1990 because of internal divisions within the party and also
within the coalition supporting it .
• A caretaker government was set up prior to new elections in May 1991.
• The political uncertainty was heightened by the assassination of Rajiv Gandhi in May 1991
• Lowering of credit ratings Increased political uncertainty, along with the negative effects of the Gulf War, led to a
downgrading by international credit rating agencies
• Additional commercial borrowing abroad was not possible Low ratings also meant that many international banks
refused to roll-over short term debt and demanded immediate repayment
The Crisis of 1991
• By June 1991 official reserves were enough for just 3 weeks imports and the country was on the verge of a default
• Lack of foreign exchange was starving domestic industry of crucial imported inputs Inflation reached 10% in
1990-91
• Poor credit-rating meant that the RBI had to transfer 47 tons of its gold reserves abroad in July 1991 as collateral
for foreign loans .
• The country was finally forced to go the IMF for a stand-by loan in order to stabilize the situation