Effects of Economic Liberalization on the Indian Economy: Industrial Policy Changes and Industrial Growth

Economic Crisis of 1991

By 1991, India faced a critical economic juncture. The fiscal deficit had ballooned to over 8% of GDP, foreign exchange reserves plummeted to cover merely three weeks of imports, and inflation exceeded 13.6%. The state-controlled economy, despite decades of Five-Year Planning and import-substitution industrialization, had generated insufficient growth. Manufacturing, while achieving diversification by the late 1980s, remained technologically obsolete and internationally uncompetitive. The preceding decade (1980-1990) had witnessed modest growth of 5.6% annually—higher than the 3.6% average of 1950-1980 but unsustainable due to fiscal deficits and external imbalances.​

Pre-Liberalization Industrial Structure

The Indian industrial economy operated under the “License Raj”—a system requiring government approval for business entry, capacity expansion, and investment. Key characteristics included:

• Extensive industrial licensing requirements for firms exceeding asset thresholds

• Reservation of 836 industries for small-scale enterprises (reduced to 749 by 2002)

• High protective tariffs and quantitative import restrictions

• Dominance of public sector enterprises across strategic sectors

• Restrictions on foreign direct investment

Though import-substitution industrialization (ISI) had diversified India’s industrial base—producing virtually all consumer goods domestically by 1990—it fostered inefficiency, technological stagnation, poor quality, and high prices. Manufacturing’s share in GDP had grown from 8.98% in 1950-51 to 16.18% by 1980, but remained stagnant thereafter.​

Part II: The 1991 Economic Reforms and Industrial Policy Changes

Key Liberalization Measures

1. De-licensing and Deregulation

The New Industrial Policy (NIP) of 1991 abolished industrial licensing for all industries except seven, restricted to strategic sectors (aerospace and defense equipment, hazardous chemicals, explosives, and tobacco products). This represented a structural break from decades of centralized control. Firms gained freedom to:​

• Invest in new capacity without government permission

• Diversify product portfolios based on market demand

• Reduce production costs autonomously

• Expand capacity according to market signals

2. Public Sector Policy Reforms

The role of the public sector was substantially reduced. Previously reserved sectors—telecommunications, civil aviation, banking, and insurance—were opened to private and foreign participation. Disinvestment programs began transferring government stakes in profitable public sector undertakings (PSUs) to private investors.​

3. Foreign Direct Investment Liberalization

Automatic approval was extended for FDI up to 51% equity in high-technology and high-investment priority industries, including capital goods, metallurgical industries, electronics, entertainment, food processing, and services. The Foreign Exchange Regulation Act (FERA) of 1973 was replaced by the more liberal Foreign Exchange Management Act (FEMA) in 1999, facilitating international transactions and capital flows.​

4. Trade Policy Reforms

• Rupee devaluation by 18% to boost exports

• Phased reduction of tariff rates toward Southeast Asian levels

• Removal of quantitative restrictions on imports

• Floating of the rupee’s exchange rate

5. Financial Sector Liberalization

Commercial banks gained autonomy to determine deposit and lending interest rates. The Reserve Bank of India’s regulatory framework evolved to enable greater institutional flexibility. The Securities and Exchange Board of India (SEBI), established in 1988, strengthened capital market regulation. These reforms enabled efficient capital mobilization and financial intermediation.​

Services Sector Liberalization

Services sector reforms yielded dramatic results, particularly in telecommunications. The National Telecom Policy (1994) and establishment of the Telecom Regulatory Authority of India (1997) systematized sector liberalization. Private participants entered basic services on a duopoly basis initially, with FDI limits eventually rising to 74% by 2005 and 100% for value-added services. These reforms created one of the world’s fastest-growing telecommunications markets.​

National Manufacturing Policy 2011

Recognizing persistent challenges in manufacturing, the government adopted the National Manufacturing Policy in 2011 with explicit objectives to:

• Increase manufacturing’s GDP share from 16% to 25% by 2022

• Generate 100 million additional jobs by 2022

• Enhance domestic value addition and technological depth

• Improve ease of doing business through rationalization and simplification of regulations

• Support MSME technological upgradation

• Develop industrial infrastructure via industrial corridors and clusters​

This policy represented an acknowledgment that liberalization alone had not resolved manufacturing sector challenges.

Part III: Macroeconomic Effects of Liberalization

GDP Growth Acceleration

Liberalization catalyzed a significant growth acceleration. Real GDP growth averaged 5.7% per annum during the 1990s, accelerating further to 7.3% during the 2000s, compared to 3.6% during 1950-1980. By 2001, cumulative income gains from liberalization policies reached approximately 25.2% above the counterfactual scenario of no reform.​

Foreign Direct Investment Surge

FDI inflows exhibited dramatic expansion post-liberalization. The CAGR of FDI increased from 19.05% pre-1991 (1981-1990) to 24.28% during 1991-2009—an approximately 165-fold increase in absolute flows. During 2011-2020, FDI totaled $343.5 billion, with manufacturing receiving over 44% of cumulative FDI, though services sectors increasingly dominated. Manufacturing sectors attracting substantial FDI included automobiles, pharmaceuticals, electrical equipment, and chemicals.

​Foreign Exchange and External Stability

Foreign exchange reserves surged from a precarious $5.8 billion in 1991 to $704.89 billion in September 2024, providing a substantial buffer against external shocks and covering over 11 months of imports. This transformation eliminated the balance-of-payments vulnerability that had precipitated the 1991 crisis.​

Export Growth and Diversification

Merchandise exports grew from $22.94 billion in 1991 to $759.93 billion by 2023—a 3,000% increase. The 1990s witnessed export growth of 17.3% annually, driven primarily by IT services and pharmaceuticals. Export composition shifted from traditional agricultural and low-value products toward high-value manufactured and service exports, including IT services, pharmaceuticals, engineering goods, and textiles.​

Part IV: Industrial Growth and Manufacturing Sector Performance

Manufacturing Growth Rate

Manufacturing Sector’s Share in India’s GDP (1950-2015)

Manufacturing growth post-1991 has been uneven and modest relative to growth in services. The period 1991-2014 recorded manufacturing growth of approximately 7% annually on average, subdivided into three phases:

• 1992-1996: High growth averaging 9.2% annually, driven by capacity expansion following de-licensing

• 1997-2002: Deceleration to approximately 4-5% growth during the East Asian crisis and subsequent global slowdown

• 2003-2014: Partial recovery to 7-8% growth during the boom years​

Industrial production, measured cumulatively, increased by 8,409% during 1951-1991, but growth rates post-1991 remained volatile and lower than in the late 1980s pre-reform period, which had recorded 8.29% annually.

Stagnation in Manufacturing’s GDP Share

Despite liberalization rhetoric, manufacturing’s share in GDP failed to expand materially:

• 1980: 16.18% of GDP

• 1990-91: 16.18% of GDP (stagnant through the 1980s)

• 2014-15: 16.00% of GDP

The National Manufacturing Policy had explicitly targeted 25% by 2022—a target that remains unachieved. This stagnation contrasts sharply with the services sector’s expansion to over 50% of GDP by 1999. This structural reorientation reflects liberalization’s asymmetric impact: services benefited disproportionately from globalization and deregulation, while manufacturing faced intensified competition without commensurate productivity gains.​

Sectoral Sources of Manufacturing Growth

Demand-side decomposition analysis reveals that manufacturing output growth sources shifted post-liberalization:

Post-liberalization, domestic demand and export expansion became dominant growth drivers, while import substitution shifted to negative territory—indicating Indian manufacturers’ reduced ability to substitute imports with domestic production. This reflects increased import competition and loss of protected markets.​

High-Growth vs. Stagnant Sectors

Services-led growth emerged as the distinctive feature of post-1991 development:

• IT and ITeS: Explosive growth, expanding from negligible base to $210+ billion annual exports

• Telecommunications: Teledensity rose from 2.32% (1999) to 64.34% (2010), with wireless connections increasing from 3.57 million (2001) to 729.58 million (2010)​

• Pharmaceuticals and Chemicals: Became global suppliers, leveraging low-cost production and intellectual property investments

• Financial Services: Rapid expansion through banking reforms and capital market development

Underperforming sectors included capital goods industries, heavy manufacturing, and labor-intensive textiles (despite export growth). The “hollowing out” of manufacturing—outsourcing to lower-cost producers, particularly China—reflected intensified global competition without corresponding productivity improvements in domestic manufacturing.​

Part V: Employment and Labor Market Effects

Jobless Growth Phenomenon

One of liberalization’s most significant negative effects has been the emergence and persistence of “jobless growth”—rapid GDP expansion accompanied by minimal employment generation. Key findings include:

• Employment Elasticity: In consumer goods manufacturing, employment elasticity turned negative post-2003, declining from modest positive elasticity in the 1990s to -0.35 in the 2003-2019 period

• Capital Deepening: Rising capital-labor ratios across manufacturing have progressively reduced employment content of output growth

• Sectoral Heterogeneity: Wood products and textiles displayed consistently negative employment elasticities, while pulp and paper registered modest absorption​

Employment generation failed to accelerate despite higher GDP growth, contrary to liberalization proponents’ expectations. The registered manufacturing sector saw declining absolute employment even during growth periods, while the unorganized sector absorbed excess labor at significantly lower wages and productivity levels.​

Regional and Sectoral Disparities

Economic benefits concentrated in urban centers and service sector hubs (Bangalore, Hyderabad, Mumbai), while rural and agricultural regions lagged. Manufacturing employment remained concentrated in traditional clusters (Ahmedabad, Delhi-NCR, Tamil Nadu), with limited geographic diffusion despite improved infrastructure.​

Part VI: Distributional Outcomes and Inequality

Poverty Reduction

Liberalization coincided with significant poverty reduction. Higher growth rates post-1991 correlated with expanded employment opportunities and increased incomes. Absolute poverty headcount ratios declined, particularly during the 2000s boom period. However, this reduction was unevenly distributed.

Rising Income Inequality

Paradoxically, liberalization widened income inequality despite poverty reduction. Key indicators include:

• Gini Coefficient: Estimated at 0.54 based on distribution studies, among the world’s highest despite India’s ranking as the fourth-most equal country by World Bank measures (reflecting global inequality levels)​

• Wealth Concentration: The richest 1% holds approximately 40.1% of national wealth, while the bottom 50% holds 3%​

• Rural-Urban Divide: Urban incomes grew significantly faster than rural incomes, widening spatial inequality

• Sectoral Concentration: Service sector workers, particularly in IT, captured disproportionate wage gains, while agricultural and manufacturing workers experienced slower income growth​

Liberalization’s structure—emphasizing capital-intensive, high-skill services—created divergent labor market outcomes: premium wages for IT professionals and financial services workers coexisted with stagnant agricultural incomes and low manufacturing wages.

Part VII: Challenges and Limitations of Liberalization

Manufacturing Stagnation

Despite de-licensing and tariff reduction, manufacturing failed to accelerate as predicted. Key constraints include:

• Infrastructure deficiencies: Poor transportation networks, inadequate power supply, and logistics inefficiencies limited manufacturing competitiveness

• Financial constraints: Manufacturing firms struggled to access low-cost capital, particularly MSMEs, due to limited financial sector development

• Labor regulations: Rigid labor laws, despite reforms, impeded firm flexibility and created incentives for capital-intensive production

• Global competition: Chinese manufacturing’s rapid expansion, supported by deliberate industrial policy, undercut Indian manufacturers lacking equivalent support​

Deindustrialization Risk

Increased imports, encouraged by tariff reduction, displaced domestic manufacturers unable to compete on price or quality. This “hollowing out” risked India’s manufacturing base without compensating through export-led growth, unlike East Asian developmental states that combined liberalization with strategic industrial policy.

Sustainability and Macroeconomic Vulnerability

Liberalization enhanced India’s integration into global financial markets, increasing exposure to external shocks. The 2008 financial crisis temporarily disrupted growth, and subsequent slowdowns reflected global demand fluctuations rather than autonomous domestic demand management.​

Part VIII: Industrial Policy Evolution Post-2014

Recognizing manufacturing sector challenges, subsequent governments introduced compensatory policies:

Make in India (2014): Aimed to position India as a global manufacturing destination through:

• Ease of doing business improvements

• Sector-specific FDI promotion

• Industrial corridor development

• Infrastructure investment

Atmanirbhar Bharat (2020): Self-reliance focused on:

• Domestic value chain development

• Production-linked incentives (PLI) for select sectors

• MSMEs support and formalization

These initiatives acknowledge that unguided liberalization, while generating growth and enabling IT/services expansion, required complementary policies to achieve balanced industrial development.