Reforms in the Financial System¶

Background¶

The pre-reforms period, spanning from the mid-1960s to the early 1990s, was characterized by administered interest rates, industrial licensing and controls, a dominant public sector, and limited competition in the Indian economy. This resulted in inefficient production systems with high costs, an inefficient allocation of resources, and high capital-output ratios. Despite increased saving rates, India remained heavily reliant on foreign aid. During this period, India's growth rate averaged less than 4% per annum, while many other developing countries achieved higher growth rates.

In the early 1990s, India faced a foreign exchange crisis due to rising world oil prices and a drop in remittances. This crisis highlighted the need for economic reforms to restore macroeconomic stability and accelerate economic growth.

Objectives of Economic Reforms¶

The government initiated economic reforms in June 1991 with two primary objectives:

Reorientation of the Economy: Transition from a statist, state-dominated, and highly controlled economy to a market-friendly one. This involved reducing direct controls, physical planning, and trade barriers.
Macro-economic Stability: Achieving macroeconomic stability by reducing fiscal deficits and the government's dependence on society's savings.

Reforms in the Financial System¶

The Indian government recognized the importance of an efficient financial system to support economic reforms. The reforms in the financial system included:

Liberalization of domestic investment.
Opening key infrastructure sectors to private sector participation.
Opening the economy to foreign competition by reducing import controls and tariffs.
Deregulation of interest rates.
Encouraging direct foreign investment for technology upgradation and non-debt finance.
Public sector reform to enhance efficiency.
Disinvestment of public sector undertakings (PSUs).
Tax system reform to broaden the tax base and moderate tax rates.

The Narasimham Committee¶

In August 1991, the Indian government established a high-level committee chaired by M. Narasimham, a former RBI governor, to examine various aspects of the financial system and recommend comprehensive reforms. The committee submitted its report in November 1991, which included recommendations for reforming both the banking sector and financial markets. These recommendations were gradually implemented in 1992.

Indian Financial System in the Pre-Reforms Period¶

In the pre-reforms period, the Indian financial system was characterized by:

Being closed, highly regulated, and government-controlled.
Lack of integration and segmentation.
Limited pricing freedom.
Restrictions on capital flows.
Barriers to entry.
High transaction costs.
Low liquidity.

Objectives of Financial System Reforms¶

Financial system reforms aimed to achieve the following objectives:

Increase competitive efficiency in the operation of the system.
Make the financial system healthy and profitable.
Impart operational flexibility and autonomy for efficient functioning.
Offer savers a wide choice of instruments and institutions.
Enhance the accumulation of capital funds.

Financial Efficiency, Stability, and Integration¶

Financial system reforms focused on improving efficiency, stability, and integration. Key measures included:

Liberalization of interest rates.
Reduction of reserve requirements.
Increasing competition through private sector participation.
Adoption of technology.
Introduction of prudential norms.
Enhancement of transparency.
Rationalization of tax structures.
Introduction of electronic payment mechanisms.

Conclusion¶

Financial system reforms played a crucial role in India's transition from a closed and regulated economy to a more market-oriented and globally integrated one. These reforms aimed to improve efficiency, stability, and integration in the financial system, facilitating economic growth and development.

Note: The information provided is a concise summary of the reforms in the Indian financial system.

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