Background

The roots of the 1991 crisis lie in the way the economy was managed through the 1980s. A government raises money to run its administration and pay for its policies from sources such as taxes and the earnings of public sector enterprises. When its spending runs ahead of its income, it covers the gap by borrowing — from banks, from citizens at home, and from international financial institutions. Imports such as petroleum have to be paid for in dollars, which the country earns mainly through its exports.

Through the 1980s the pressures of development forced spending well beyond revenue. The government had to tackle unemployment, poverty and a rising population, yet its ongoing development spending did not generate matching new income, and it could not raise enough from internal sources like taxation. Large shares of revenue went to areas that yield no quick return, such as the social sector and defence, so the rest had to be used very efficiently — but earnings from public sector undertakings stayed low. Worse, borrowed foreign exchange was at times used to meet consumption rather than productive needs, wasteful spending was not curbed, and too little was done to lift exports to pay for growing imports.

By the late 1980s the shortfall between spending and revenue had grown so wide that financing it through borrowing became unsustainable. Prices of essentials shot up, imports grew far faster than exports, and foreign exchange reserves shrank to a level that could not fund even two weeks of imports — nor even the interest owed to foreign lenders. No country or international lender was willing to extend fresh credit.

India then turned to the World Bank (formally the International Bank for Reconstruction and Development, IBRD) and the International Monetary Fund (IMF), and received seven billion dollars as a loan to ride out the crisis. In return, these agencies expected India to open up and liberalise the economy — easing restrictions on the private sector, shrinking the government's role in many areas, and removing barriers to trade with other countries. Accepting these conditions, India announced the New Economic Policy (NEP), a broad package of reforms meant to make the economy more competitive and to clear away obstacles to the entry and growth of firms. …