Background to 1991 Economic Reforms
From the mid-1960s until the early 1990s India operated under a heavily managed economic framework marked by administered interest rates, extensive industrial licensing and controls, a dominant public sector, and limited competition. These policies produced uneconomic and inefficient production structures with high costs and poor use of resources, reflected in high capital–output ratios. Even as savings rose, the economy remained dependent on foreign aid and assistance to meet urgent needs. Over this long period, India’s average growth rate stayed below 4 per cent per annum, while several less-developed and East Asian economies grew at over 5 per cent and, in cases such as Japan and the newly industrializing East Asian countries, were able to catch up with Western industrial nations by pursuing more market-oriented industrialisation.
From the early 1980s the government began cautiously easing some constraints. Entry barriers were relaxed, restrictive provisions of the Monopolies and Restrictive Trade Practices (MRTP) Act were removed, capacity expansion and industrial modernisation were encouraged, import restrictions were eased, the yields on long-term government securities were raised, and steps were taken to develop the money market. These measures helped accelerate growth in the latter half of the 1980s, but the momentum proved hard to sustain in the absence of deeper, systemic changes.
The immediate crisis that precipitated decisive reform in the early 1990s followed external shocks and longstanding domestic weaknesses. A rise in world oil prices after the Gulf War and a sharp fall in remittances from Indian workers in the Gulf triggered a foreign exchange squeeze. Fears that the government might default on external obligations prompted capital outflows that worsened the situation. Yet the crisis had deeper roots in a persistently large central government deficit and an inward-looking economic strategy that produced chronic macroeconomic imbalances. The government thus faced two linked tasks: to restore macroeconomic stability by cutting fiscal and balance-of-payments deficits, and to complete the process of structural reforms begun in the 1980s.
In June 1991 the government launched a comprehensive reform programme with two principal objectives. First, it sought to reorient an economy that had been statist, state-dominated and highly controlled toward a market-friendly framework by reducing direct controls, scaling back physical planning, and lowering trade barriers. Second, it aimed to secure macroeconomic stability by substantially reducing fiscal deficits and the government’s claim on society’s savings. Achieving these twin aims required both stabilisation and a structural adjustment strategy based on liberalisation and greater integration with the world economy; the government therefore adopted a phased approach to opening up various sectors.
The reform package was wide-ranging. It liberalised domestic investment policy and opened key infrastructure sectors to private participation. The economy was exposed to foreign competition by reducing import controls and high tariff protection, interest rates were deregulated, and foreign direct investment was encouraged as a source of technology transfer and non-debt finance. Public sector reform, including disinvestment of public sector undertakings, and tax reforms aimed at broadening the tax base while moderating rates, were also important elements of the programme.
Since liberalisation of industry, foreign exchange markets and eventual convertibility required a robust financial architecture, strengthening the financial system became an integral part of the reforms. A more efficient financial system was expected to improve resource mobilisation and allocation in the real economy, thereby supporting a higher rate of sustainable growth; at the same time, a sound financial system is a basic indicator of an economy’s health.
To guide financial sector reform, the government appointed in August 1991 a high-level committee chaired by former Reserve Bank of India governor M. Narasimham to review the financial system and propose comprehensive reforms. The committee’s report, submitted in November 1991, recommended far-reaching changes in banking and financial markets, and its recommendations began to be implemented from early 1992.
State-Dominated Financial System
Two decades ago, financial systems in many developing countries were seen mainly as instruments of the state’s development agenda. Governments tapped financial institutions for funds to meet public expenditure and directed credit toward designated priority sectors. Over time this perspective shifted. Disillusionment with the state’s ability to meet social and growth objectives brought the private sector to the fore, and the private sector, to survive and expand, needs a well‑developed financial system. In an increasingly globalised and competitive world, a steady flow of funds — domestic and foreign — is essential for growth, and a robust domestic financial system is a prerequisite to attract and absorb that flow.
This change was not confined to developing countries. Worldwide, the emphasis moved away from simply channelising resources under administrative controls toward ensuring that credit is allocated efficiently — a process increasingly shaped by market forces. The experience of the South‑East Asian financial crisis also underlined that efficiency alone is not enough: financial stability must receive equal priority in any modern financial architecture.
India’s post‑independence model exemplified the older, state‑dominated approach. Allocation decisions were made by the government and its agencies, and development strategy focused on accelerated capital accumulation by raising domestic savings. Higher taxes, suppressed consumption and direct public ownership of enterprises were used to mobilise resources. Within this framework the financial system played a limited role. Commercial banks remained the dominant institutions for mobilising savings and financing trade and industry, but controls on interest rates, together with high statutory reserve and cash reserve requirements, constrained their role in capital formation. In practice banks largely functioned as deposit agencies rather than as active allocators of capital.
Controls extended to the primary capital market as well, obstructing price discovery and leaving allocation decisions to the state. Credit was directed to priority sectors at subsidised rates set by the government; to compensate, banks charged higher rates to other borrowers and paid lower rates to depositors. Such interest‑rate controls and heavy regulation distorted resource pricing and curtailed the allocative efficiency of the system. Until the early 1990s, therefore, the Indian financial system remained closed, tightly regulated and segmented.
By the 1990s a paradigm shift took place: policy moved from a state‑dominated model to a market‑determined strategy. This change reflected the government’s inability to sustain higher growth, generate sufficient resources for investment and public services, and maintain public savings. The failure of restrictive, administratively driven policies, together with the need to revitalise growth, prompted comprehensive financial sector reforms aimed at enhancing both the operational efficiency of financial institutions and the allocative efficiency of the financial system as a whole.
Objectives and Evolution of Financial Reforms
Financial-sector reforms were designed to make the financial system more competitive, healthier and profitable, and to give it greater operational flexibility and autonomy. By widening the range of instruments and institutions available to savers and by strengthening public confidence in the system, these reforms sought to deepen savings and significantly increase the pool of capital available for investment.
The initial phase of reforms concentrated on removing structural rigidities and inefficiencies that had built up over decades. In the 1980s and early 1990s the system was marked by administered pricing of financial assets, quantitative restrictions on transactions and flows, barriers to entry for new players, low liquidity and relatively high costs. These features prevented the financial sector from functioning as an effective channel for mobilising and allocating resources, slowing financial development and constraining economic growth.
To correct these weaknesses, policy changes emphasised structural transformation: allowing market-determined pricing of financial assets, relaxing quantitative controls, reducing entry barriers, introducing new trading methods and instruments, and strengthening clearing, settlement and disclosure practices. With those institutional changes largely in place, the focus has shifted to the next phase: balancing the twin objectives of financial stability and the creation of integrated, efficient markets.
Financial System Efficiency, Stability and Integration
Improving the efficiency of the financial system is a core objective of regulators because an efficient system channels savings into the most productive uses. Efficiency goes beyond simple allocation of resources: it requires that market prices incorporate available information (information arbitrage efficiency), that stock prices reflect firms’ true valuations (fundamental valuation efficiency), and that economic agents have the means to insure against foreseeable contingencies (full insurance efficiency).
A financial system comprises two broad pillars—financial markets and financial institutions—and the system’s overall efficiency depends on the performance of both. Policy reforms to strengthen the banking sector have included liberalising interest rates, lowering reserve requirements, encouraging competition by admitting new private-sector players, and adopting modern technology. Regulators have also introduced prudential norms—such as clearer rules on income recognition, provisioning and capital adequacy—and set standards for corporate governance to improve institutional soundness. On the markets side, measures such as the repeal of the Capital Issues (Control) Act, 1947, the move to free pricing and book-building mechanisms, stricter disclosure requirements, better trading and settlement systems, a transparent takeover code, and incentives for firms to grow domestically and internationally have enhanced price discovery and transparency. Improvements in tax treatment, market practices and electronic payment systems — including RTGS (Real Time Gross Settlement) — have reduced transaction costs and supported information efficiency.
The need to safeguard financial stability became particularly prominent after the South‑east Asian currency and financial crises. Globalisation has increased the mobility of capital and the risk that turbulence in one country spreads to others; liberalisation and deregulation, while beneficial, also introduce new vulnerabilities. Financial instability typically stems from weak economic fundamentals or institutional failures, which can trigger panic or information asymmetries. As articulated in the Reserve Bank of India’s Report on Currency and Finance (2004), financial stability in India implies uninterrupted financial transactions, sustained confidence among participants, and the absence of excessive volatility that could harm real economic activity.
To protect stability, the government and the Reserve Bank have pursued complementary strategies. The government has emphasised three broad pillars: strengthening linkages across institutions and markets, promoting the soundness of financial entities through prudential regulation and supervision, and preserving overall macroeconomic balance. The Reserve Bank’s three‑pronged approach focuses on maintaining macroeconomic stability (notably price stability alongside growth), enhancing macro‑prudential oversight of institutions and markets, and reinforcing micro‑prudential soundness through regulation and supervision. Operationally, the RBI uses flexible monetary instruments—including Liquidity Adjustment Facility (LAF) operations and open market operations—to manage liquidity and maintain orderly market conditions. The Bank also introduced the Market Stabilization Scheme (MSS) to absorb persistently large capital inflows; such measures helped financial markets withstand the volatility that followed the general election results on 17 May 2004.
Because the financial system operates within the broader economy, assessing its soundness requires a set of macro‑prudential indicators—quantitative measures that combine micro‑prudential metrics on individual institutions with macroeconomic variables related to system stability. These indicators help gauge a banking system’s vulnerability to crises and can be applied to financial markets as well. The Reserve Bank monitors and publishes these indicators to improve market transparency. Macro indicators typically cover real activity, balance‑of‑payments trends, and volatility in inflation, interest and exchange rates, credit growth, market correlations, trade spillovers and investor‑driven contagion. Micro indicators focus on capital adequacy, asset quality of lenders and borrowers, management soundness, liquidity, sensitivity to market risk, and market‑based signals such as prices and credit ratings. To strengthen fiscal and monetary coordination, the government moved away from ad hoc treasury bill financing toward a structured system of ways and means advances.
Greater integration across markets—where participants can access different segments without restriction—improves policy transmission and market functioning. Until the early 1990s, the money, capital and foreign exchange markets in India were largely segmented by regulation. Integration has been promoted by freeing interest rates, permitting foreign capital flows and foreign participants, allowing domestic firms to raise funds abroad, and enabling participants to operate simultaneously across markets. The introduction of new instruments (repos and derivatives), along with upgrades in technology and payments and settlement infrastructure, further accelerated integration. Evidence of this integration appears in the co‑movement of turnover and prices across markets and in the transmission of volatility from one segment to another—for example, the linkages between the call money market and the foreign exchange market during episodes of FX stress, given commercial banks’ dominant presence in both. Cross‑border financial integration increased with rising foreign investment flows; a case in point is the heightened sensitivity of Indian technology stocks to the NASDAQ during 1999–2000, and the broader correlation between domestic and global stock indices. Domestically, the expansion of online trading by the BSE and the NSE and the linking of regional exchanges through the Interconnected Stock Exchange of India Ltd have deepened market integration, with many regional exchanges becoming members of the larger national bourses.
Financial System: Vulnerabilities and Reforms
The Indian financial system today is broadly integrated, reasonably stable and functioning efficiently in many respects, yet important vulnerabilities remain. Prominent weaknesses include elevated non-performing assets in some banks and financial institutions, governance and disciplinary lapses among certain non-banking financial companies, high government domestic debt and borrowings, market volatility, the absence of a well-signalled yield curve and recurring problems in cooperative banks. These structural and institutional gaps weaken the system’s ability to allocate capital smoothly and absorb shocks.
Past crises in major public institutions such as UTI, IFCI and IDBI exposed shortcomings in prudential regulation and supervisory oversight. Government bailouts and refinancing of these entities undermined investor confidence in public sector institutions and contributed to a slowdown in domestic saving. Although foreign capital inflows and foreign exchange reserves have risen, actual absorption of foreign capital remains limited. At the same time, an expanding fiscal deficit, the global fallout from the sub-prime mortgage crisis, high inflation and a depreciating rupee have exerted downward pressure on GDP growth and fiscal stability.
India’s GDP growth has accelerated since 2003–04, but sustaining higher growth will require concerted reforms. Achieving and maintaining rates around 8 per cent demands reforms in core sectors such as agriculture, power and labour markets. Financial sector policy should promote greater consolidation and competition among banks and other intermediaries—mutual funds and insurance companies—to reduce intermediation costs and extend credit and insurance more deeply into rural areas. Ongoing liberalisation in retailing, manufacturing, mining and insurance should be continued, and sectoral caps on foreign direct investment relaxed where appropriate to attract larger, long-term foreign capital inflows, especially into financial services. Addressing these institutional and sectoral constraints is essential for durable, inclusive growth.
Structural Reforms and Economic Growth
The economic reforms of the 1990s marked a decisive shift in India’s policy orientation — from a closed, heavily regulated economy to one guided increasingly by market principles and global integration. Introduced to boost efficiency, competitiveness and long-term stability, these structural reforms touched every major sector. They eased controls, reduced statutory constraints and gradually opened the economy to international trade and capital flows, while coordinating with broader macroeconomic policy and global trends.
The cumulative effect of these measures was pronounced. By dismantling the licence‑raj and removing many trade and tax bottlenecks, the reforms revived investment in manufacturing, widened consumer choice and encouraged foreign firms to enter the Indian market, thereby intensifying competition. New export engines emerged: software and IT‑enabled services and business process outsourcing became globally recognised strengths, while pharmaceuticals, auto and engineering products also contributed to export growth. Indian industry restructured, expanded capacities, raised quality and became increasingly competitive internationally.
Financial sector reforms were central to this transformation. A programme of deregulation and strengthened prudential norms fostered a more resilient and efficient banking and financial system. Interest rates were gradually liberalised, supervisory and accounting standards were tightened, and the ownership and operational scope of financial institutions changed to introduce greater competition. Capital markets were modernised — on‑line trading, dematerialisation, rolling settlement and enhanced disclosure practices addressed earlier frailties, and the time between issue closure and listing fell from about 15 days to six. Foreign institutional investors became prominent participants, and the stock market at its peak reflected buoyant investor interest (the index reached about 21,000 in January 2008).
Institutional reform extended beyond finance. Sectoral regulators emerged for telecom, power, hydrocarbons and insurance, while the Reserve Bank of India acquired de facto greater autonomy in its monetary and supervisory roles. The telecom revolution, together with the rise of the IT industry, amplified the reach and productivity of services, urban construction and commercial development — new growth was concentrated heavily in urban and semi‑urban centres, driven by infrastructure, IT parks and related services.
A landmark institutional innovation in payments came with the setting up of the National Payments Corporation of India in 2008. Alongside the Aadhaar initiative, this enabled widespread adoption of electronic payments and became a platform for deeper financial inclusion. Over the same period, India’s financial system integrated more closely with the global economy: flows of capital rose, trading volumes expanded and market liquidity improved, while regulators continued to strengthen oversight.
The economic payoff is visible in macro‑outcomes. After a low point in 1991 when growth fell to around 0.8 per cent, sustained reform delivered much higher growth rates — the economy recorded multi‑year averages well above the pre‑reform era and moved away from the so‑called Hindu rate of growth of about 3.5 per cent. For the period 2003–04 to 2015–16 the average growth was about 7.7 per cent, despite external shocks such as the 2008 global financial crisis and the 2011 Eurozone disturbance. Social indicators also improved: poverty declined faster in 2004–05 to 2011–12 than in earlier decades, and access to services expanded rapidly — for example, telephone subscribers grew from roughly 0.5 million in 1991 to nearly 980 million by 2016, passenger car sales rose from about 0.18 million to 2.7 million, and air passengers increased from roughly 10 million to 100 million over the same span. Nominal GDP expanded substantially as well, from about Rs 10.8 lakh crore in 1991 to roughly Rs 135.7 lakh crore by 2016.
Taken together, these changes explain why India has been among the faster‑growing major economies in recent decades. Over a 25‑year horizon India’s average growth has been in the high single digits, second only to China among large Asian economies, and the country’s economic story today is one of deeper markets, stronger institutions and a broader base for future growth.