The Success of India’s Liberalization in 1991

This is an excerpt from a report on the failure of industrial policy in India and the success of its liberalization policies in 1991. To download the full report, click here.

There is an everlasting debate about which policies a country should implement in order to encourage economic growth. Is it better for a government to intervene and choose which industries to develop, or should it allow the private sector to decide what to produce?

While there are success stories of countries that have followed industrial policies, such as the Asian tigers in the 1960s and 1990s, there are also stories of failure, such as India in the decades prior to the 1990s. What led to the economic miracle in India during the 1990s?

Before Liberalization

The Indian government sought to encourage industrialization by directing investment toward the production of capital goods and by restricting imports. At the same time, it tried to help its poorest citizens, who lived in rural areas. As a result, the return on capital in the public sector during the 1980s was only 1.5 percent.^[1]

The private sector suffered under other restrictions, including the following:^[2]

• Import restrictions that did not permit the free exchange of goods and knowledge
• Antitrust laws that did not allow businesses to grow
• Public monopolies that operated very inefficiently
• The License Raj, which complicated the process of opening new businesses

So it is not surprising that GDP per capita grew at an annual rate of only 3.5 percent in the years prior to the 1980s.^[3] Considering how poor India was, even in the following decade, (GDP per capita was $447 in 1985), the growth rates were alarming. They were not high enough to lift the population out of poverty.

Like many other countries that no are unable to produce enough to finance their government projects through taxation, India financed itself with public debt. In 1991, the public debt reached $70 billion and India was on the verge of declaring bankruptcy. To avoid this disastrous last resort, India was forced to take immediate action to fix the problem.

The Economic Liberalization

In 1991, the Indian government broke with industrial policy, which had failed. In a surprising 180-degree twist, the new policies encouraged business activity, stimulated growth in the private sector, and revived international trade.

Some of the most important measures include:^[4]

• Eliminating the industrial license requirement for most sectors
• Removing limits on capital accumulation
• Eliminating licenses for importing the majority of goods
• Reducing tariffs
• Opening the private sector to many activities that had previously been reserved for the public sector
• Reducing requirements for bank reserves and restrictions on interest rates
• Eliminating restrictions on foreign investment

Liberalization achieved the desired results, as reflected by the following data:^[5]

• GDP per capita grew at an annual rate of 6 percent in the 1990s, driven by the service sector, which would come to represent 53.5 percent of GDP by 1999.
• Exports grew at an annual rate of 17.3 percent during the 1990s, in large part because of a boom in the software sector.
• India’s score on the Fraser Institute’s Index of Economic Freedom rose from 4.8 in 1990 to 6.2 in 2000, reflecting remarkable improvements in the freedom to trade internationally.

How Do We Know Whether India’s Economic Development Was the Result of Liberalization Policies?

Although the economy grew after liberalization, one could argue that this is a coincidence and that the growth was really a belated effect of the previous industrial policies. It could also be argued that economic growth would have occurred even without any policy changes.

To determine whether the improvements in the Indian economy were a result of liberalization reforms, we apply the synthetic-control method. This is a statistical method in which researchers compare a unit that received a treatment with a combination of units that did not receive the treatment. In this case, the unit is a country and the treatment is liberalization policies. We compare the treated unit to countries that did not implement liberalization policies. The synthetic control creates a synthetic unit—an imaginary country that never received the treatment. The synthetic unit permits us to consider how certain variables would have developed in the absence of the treatment.^[6]

We use GDP per capita as the indicator of economic growth. If the GDP per capita of the synthetic India behaves the same way as that of the real India, we cannot conclude that liberalization caused the exceptional growth of the 1990s.

Creating the Synthetic Control

To create a synthetic India, we must choose a group of countries whose combination best resembles India. The selection criteria to achieve this are the following:

• Countries that did not undergo any kind of economic reform during the period under study
• Countries that did not have special factors affecting their economic performance, such as wars or crises
• Countries that were also poor at the beginning of the period
• Countries located near India

These filters reduce the donor pool to thirteen Asian and African countries, out of which the model selected four: Nepal, Pakistan, Eswatini, and Bangladesh. This combination of countries best mirrors India’s economic performance prior to 1991.

Result: India’s Economic Liberalization Was a Resounding Success

Figure 1 shows the results of the synthetic-control test.

The synthetic India mirrors the real India prior to liberalization, represented by the vertical line. After liberalization, the synthetic India clearly diverges from the real India. This can be seen more clearly in the following figure, which shows the gaps in GDP per capita between the two units.

The gap did not exceed $17 prior to 1991. However, the gap became exponentially wider after 1991, reaching $158 in 2001. This gap may seem small, but one must remember that these gaps represent a significant increase in income for Indian citizens and are a direct result of the liberalization. In 2001 the cumulative increase was 25.2 percent. This means that, thanks to liberalization, Indian citizens’ incomes were 25 percent greater than what their incomes would have been had the liberalization policies not been implemented.

Will All Liberalizations Yield Similar Results?

This is a specific case tied to the specific conditions in India during those years. If there were a perfect formula for achieving economic growth, all countries would follow it and these debates would not exist. Although we cannot extrapolate generalized conclusions from this particular case, economic theory does support the idea that these kinds of policies are beneficial in many ways.

For more about the theory that explains the failure of industrial policies and the success of liberalization, read our special report on India.

References

Abadie, A., Diamond, A., & Hainmueller, J. (2010). Synthetic Control Methods for Comparative Case Studies: Estimating the Effect of California’s Tobacco Control Program. Journal of the American Statistical Association, 105, 493-505.

Emran, M. S., Shilpi, F., & Alam, M. I. (2007). Economic Liberalization and Price Response of Aggregate Private Investment: Time Series Evidence from India (Libéralisation économique et réponse des prix de l’investissement privé agrégé: résultats enregistrés par les séries chronologiques pour l’Inde) . The Canadian Journal of Economics / Revue canadienne d’Economique, 40, 914–934.

Kotwal, A., Ramaswami, B., & Wadhwa, W. (2011). Economic Liberalization and Indian Economic Growth: What’s the Evidence? Journal of Economic Literature, 49, 1152–1199.

Thakur, R. (1993). Restoring India’s Economic Health. Third World Quarterly, 14, 137-157.

Legal notice: the analysis contained in this article is the exclusive work of its author, the assertions made are not necessarily shared nor are they the official position of the Francisco Marroquín University.

–

[1] Thakur 1993.

[2] Kotwal, Ramaswami, & Wadhwa 2011.

[3] Kotwal, Ramaswami, & Wadhwa 2011.

[4] Emran, Shilpi, & Alam 2007.

[5] Kotwal, Ramaswami, & Wadhwa 2011.

[6] Abadie, Diamond, & Hainmueller, 2010.

[7] The average annual error is minimal. It is only 2.34 percent of the actual values.