UNIT - 6

New Economic Policy of 1991: Objectives, Features and Impacts

New Economic Policy of India was launched in the year 1991 under
the leadership of P. V. Narasimha Rao. This policy opened the door
of the India Economy for the global exposure for the first time. In
this New Economic Policy P. V. Narasimha Rao government reduced
the import duties, opened reserved sector for the private players,
devalued the Indian currency to increase the export. This is also
known as the LPG Model of growth.

New Economic Policy refers to economic liberalisation or relaxation

in the import tariffs, deregulation of markets or opening the
markets for private and foreign players, and reduction of taxes to
expand the economic wings of the country.

Former Prime Minister Manmohan Singh is considered to be the

father of New Economic Policy (NEP) of India. Manmohan Singh
introduced the NEP on July 24,1991.

Main Objectives of New Economic Policy – 1991, July 24

The main objectives behind the launching of the New Economic

policy (NEP) in 1991 by the union Finance Minister Dr.
Manmohan Singh are stated as follows:
1. The main objective was to plunge Indian Economy in to the
arena of ‘Globalization and to give it a new thrust on market
orientation.
2. The NEP intended to bring down the rate of inflation
3. It intended to move towards higher economic growth rate and to
build sufficient foreign exchange reserves.
4. It wanted to achieve economic stabilization and to convert the
economy into a market economy by removing all kinds of un-
necessary restrictions.
5. It wanted to permit the international flow of goods, services,
capital, human resources and technology, without many
restrictions.
6. It wanted to increase the participation of private players in the all
sectors of the economy. That is why the reserved numbers of
sectors for government were reduced. As of now this number is just

Beginning with mid-1991, the govt. has made some radical changes
in its policies related to foreign trade, Foreign Direct Investment,
exchange rate, industry, fiscal discipline etc. The various elements,
when put together, constitute an economic policy which marks a
big departure from what has gone before.
The thrust of the New Economic Policy has been towards creating
a more competitive environment in the economy as a means
to improving the productivity and efficiency of the system. This
was to be achieved by removing the barriers to entry and the
restrictions on the growth of firms.
List of all Five Year Plans of India
Main Measures Adopted in the New Economic Policy
Due to various controls, the economy became defective. The
entrepreneurs were unwilling to establish new industries ( because
laws like MRTP Act 1969 de-motivated entrepreneurs). Corruption,
undue delays and inefficiency risen due to these controls. Rate of
economic growth of the economy came down. So in such a scenario
economic reforms were introduced to reduce the restrictions
imposed on the economy.

Liberalization

• The process of making policies less restrictive of economic activity,

as well as the lowering of tariffs or the removal of non-tariff barriers
is known as liberalisation.

• Prior to 1991, the government put a variety of restrictions on

domestic private companies.
• The industrial licensing system, price control or financial control
on goods, import licence, foreign exchange control, limits on major
company investment, and so on were among them.

• The term "liberalisation of the economy" refers to the liberation of

manufacturing units from government-imposed direct or physical
restrictions.

• The government saw that as a result of these regulations, a

number of flaws had arisen in the economy.

• The NEP believed economic liberalisation to be a critical

component. Market forces, rather than checks and regulations,
were to be relied on more heavily.

• Reforms in the Industrial Sector: o Abolition of Industrial

Licensing: A new industrial policy was launched in July 1991.
Except for the following five industries, it repealed the licencing
requirement. Liquor (a), cigarettes (b), defence equipment (c),
industrial explosives (d), and hazardous chemicals (e). o Public
sector contraction: The number of industries allocated for the
public sector has been decreased from 17 to 8 under the new
industrial policy. The number of these industries decreased to only
two in 2010-11: i. Nuclear Power and ii. Railways.

• Financial Sector Reforms: o The Reserve Bank of India (RBI)

regulates and controls the financial industry in India (Reserve Bank
of India). o The RBI's function shifted significantly from "regulator"
to "facilitator" of the financial industry as a result of liberalisation. o
In the Indian banking industry, the free play of market forces has
resulted in the rise of private bankers, both domestic and
international. o Foreign institutional investors (FIIs) were also
allowed to invest in Indian financial markets as a result of the
liberalisation.

• External Sector Reforms: o Foreign exchange reforms and foreign

trade policy changes are two examples of external sector reforms. o
Devaluation of the Indian rupee versus foreign currencies began
foreign exchange liberalization in 1991. o Devaluation refers to the
decrease in the value of our currency in comparison to other
currencies.

• Fiscal Reforms: o Fiscal reforms deal with the government's

revenue and expenditure. o Fiscal changes are mostly tax
measures. o Taxes are divided into two categories: a) direct taxes
and b) indirect taxes.

Following steps were taken under the Liberaliation measure:

(i) Free determination of interest rate by the commercial
Banks:
Under the policy of liberalisation interest rate of the banking system
will not be determined by RBI rather all commercial Banks are
independent to determine the rate of interest.

(ii) Increase in the investment limit for the Small Scale

Industries (SSIs):
Investment limit of the small scale industries has been raised to Rs.
1 crore. So these companies can upgrade their machinery and
improve their efficiency.

(iii) Freedom to import capital goods:

Indian industries will be free to buy machines and raw materials
from foreign countries to do their holistic development.

(v) Freedom for expansion and production to Industries:

In this new liberalized era now the Industries are free to diversify
their production capacities and reduce the cost of production.
Earlier government used to fix the maximum limit of production
capacity. No industry could produce beyond that limit. Now the
industries are free to decide their production by their own on the
basis of the requirement of the markets.

(vi) Abolition of Restrictive Trade Practices:

According to Monopolies and Restrictive Trade Practices (MRTP)
Act 1969, all those companies having assets worth Rs. 100 crore or
more were called MRTP firms and were subjected to several
restrictions. Now these firms have not to obtain prior approval of
the Govt. for taking investment decision. Now MRTP Act is replaced
by the competition Act, 2002.
1. Liberalisation
Removal of Industrial Licensing and Registration:
Previously private sector had to obtain license from Govt. for
starting a new venture. In this policy private sector has been freed
from licensing and other restrictions.

Industries licensing is necessary for following industries:

(i) Liquor
(ii) Cigarette
(iii) Defence equipment
(iv) Industrial explosives
(v) Drugs
(vi) Hazardous chemicals

2. Privatisation:

• The process of engaging the private sector in the ownership or

operation of a state-owned business is known as privatisation. It
entails the progressive transfer of government ownership and
control of public-sector businesses.

• Privatization entails giving the private sector a larger role while

diminishing the role of the public sector.

• Disinvestment is the privatisation of public sector businesses by

selling a portion of their stock to the general public.
• The government took the following actions to carry out its
privatisation policy:

• Disinvestment in the public sector, or the transfer of a public-

sector company to the private sector.

• The Industrial and Financial Reconstruction Board was

established (BIFR). This board was formed to help ill units in
public-sector businesses that were losing money.

• The government's stake is being diluted. If the private sector

obtains more than 51 percent of the shares throughout the
disinvestment process, ownership and management are transferred
to the private sector.
Simply speaking, privatisation means permitting the private sector
to set up industries which were previously reserved for the public
sector. Under this policy many PSU’s were sold to private sector.
Literally speaking, privatisation is the process of involving the
private sector-in the ownership of Public Sector Units (PSU’s).

The main reason for privatisation was in currency of PSU’s are

running in losses due to political interference. The managers cannot
work independently. Production capacity remained under-utilized.
To increase competition and efficiency privatisation of PSUs was
inevitable.

Step taken for Privatisation:

The following steps are taken for privatisation:
1. Sale of shares of PSUs:
Indian Govt. started selling shares of PSU’s to public and financial
institution e.g. Govt. sold shares of Maruti Udyog Ltd. Now the
private sector will acquire ownership of these PSU’s. The share of
private sector has increased from 45% to 55%.

2. Disinvestment in PSU’s:
The Govt. has started the process of disinvestment in those PSU’s
which had been running into loss. It means that Govt. has been
selling out these industries to private sector. Govt. has sold
enterprises worth Rs. 30,000 crores to the private sector.

3. Minimisation of Public Sector:

Previously Public sector was given the importance with a view to
help in industralisation and removal of poverty. But these PSU’s
could not able to achieve this objective and policy of contraction of
PSU’s was followed under new economic reforms. Number of
industries reserved for public sector was reduces from 17 to 2.
(a) Railway operations
(b) Atomic energy

Globalization:
Literally speaking Globalisation means to make Global or
worldwide, otherwise taking into consideration the whole world.
Broadly speaking, Globalisation means the interaction of the
domestic economy with the rest of the world with regard to foreign
investment, trade, production and financial matters.
• Globalisation is the term used to describe the global integration of
diverse economies• Until 1991, the Indian government had a tight
policy on imports and foreign investment,including licencing of
imports, tariffs, and other restrictions, but with the new policy,
thegovernment adopted a globalisation strategy, adopting the
following steps:

o Liberalization of imports. Many limitations on capital goods

imports were lifted by the government.

o The Foreign Exchange Regulation Act (FERA) was repealed, and

the Foreign Exchange Management Act was enacted in its stead
(FEMA)

o Tariff structure rationalisation

o Duty on exports is abolished.

• Physical and political boundaries were no longer a barrier to

economic operation as a result of globalisation. The entire globe is
transformed into a global community.

• Globalisation brings more connection and interdependence

amongst the many nations that make up the global economy.

• Outsourcing:

o Outsourcing is when a firm contracts a company to offer a regular

service that was previously done internally.
o It's a result of globalisation. India has become a key supplier of
outsourcing employment as a result of new economic policies. BPO,
banking services.

Steps taken for Globalisation:

Following steps are taken for Globalisation:
(i) Reduction in tariffs:
Custom duties and tariffs imposed on imports and exports are
reduced gradually just to make India economy attractive to the
global investors.

(ii) Long term Trade Policy:

Forcing trade policy was enforced for longer duration.

Main features of the policy are:

(a) Liberal policy
(b) All controls on foreign trade have been removed
(c) Open competition has been encouraged.

(iii) Partial Convertibility of Indian currency:

Partial convertibility can be defined as to convert Indian currency
(up to specific extent) in the currency of other countries. So that the
flow of foreign investment in terms of Foreign Institutional
Investment (FII) and foreign Direct Investment (FDI).

This convertibility stood valid for following transaction:

(a) Remittances to meet family expenses
(b) Payment of interest
(c) Import and export of goods and services.

(iv) Increase in Equity Limit of Foreign Investment:

Equity limit of foreign capital investment has been raised from 40%
to 100% percent. In 47 high priority industries foreign direct
investment (FDI) to the extent of 100% will be allowed without any
restriction. In this regard Foreign Exchange Management Act
(FEMA) will be enforced.

If the Indian economy is shining at the world map currently, its sole
attribution goes to the implementation of the New Economic Policy
in 1991.

The Impact Of The LPG Reforms Positive Impact:

• The rate of growth of India's GDP has risen. India's GDP growth
rate was only 1.1 percent in 1990-91, but following 1991 reforms, it
rose year by year, reaching 7.5 percent in 2015- 16, according to
the IMF.

• Since 1991, India has established itself as a profitable foreign

investment destination, with FDI equity inflows totaling US$ 19.33
billion in 2019-20.

• Exports climbed to USD 26.38 billion in October of this

year.Because of the rise in employment, per capita income grew.
• The unemployment rate was high in 1991, but when India
implemented a new LPG strategy, more jobs were created as new
international firms arrived in India and many new entrepreneurs
established businesses as a result of liberalisation. Negative Impact:
• Agriculture employed 72 percent of the population in 1991 and
generated 29.02 percent of GDP.

• Agriculture's share of GDP has dropped dramatically to 18%.

Farmers' per capita income has decreased as a result, and rural
indebtedness has increased.

• As the Indian economy has been more open to international

competition, more multinational corporations (MNCs) are competing
with local firms and enterprises that are struggling owing to
financial limitations, a lack of sophisticated technology, and
inefficient manufacturing.

• Globalization has also led to environmental damage through

pollution from industrial facilities and the removal of natural cover.
It also has an impact on people's health.

• LPG policies have widened the country's economic disparities. An

economy's greater growth rate is accomplished at the price of
people's wages, which may be reduced as a result of job losses.
Impact of Liberalisation, Privatisation,
and Globalisation
In the early 1990s, India faced a major crisis followed by a foreign exchange
deficit, resulting in its economic downfall. To overcome the crisis, the
government came up with adjustments to the economy by bringing new
reforms. The reforms introduced were called ‘structural reforms’ and launched
under the ‘New Economic Policy (NEP)’.
The New Economic Policy was introduced in 1991. There are three broad
concepts of New Economic Policy: Liberalisation, Privatisation, and
Globalisation, or the LPG Model. The LPG Model was introduced to replace the
LQP Model, i.e., Licensing, Quotas, and Permits. The main aim of introducing
the reforms was to attain a high rate of economic growth, reduce the rate of
inflation, reduce the fiscal deficit, and overcome the BoP (Balance of Payment)
crisis.
Liberalisation
Liberalisation of the economy is considered a key component of NEP. Before the
New Economic Policy of 1991, the private sector was in control of the
government. Because of this, the domestic industries were not allowed to take
any decisions regarding the industry’s work without the government’s
interference. This resulted in a fall in professionalism and inefficiency of work
within the industry. With the introduction of the liberalisation policy, this
sector gained the freedom of decision-making without any interference from the
government.

The government also decided to abolish the licensing system. Before 1991, a
business needed to get a license from the government to start any industrial
activity. This resulted in a delay in getting a license, as there was a long queue
of people before the window of the government department, seeking
authorisation to get a license. This also resulted in corruption as the officers
started taking bribes to make the process faster. To end this, the government
abolished the licensing system and permitted individuals to start their
industrial activities without any permission (however permission is still
required in industries, such as medicine, defense equipment, etc.).

Privatisation
Privatisation refers to the partial or full ownership and operation of the public
sector enterprises by the private sector. It implies the withdrawal of
government ownership from the public sector. It can be done in two ways:

1. Outright sale of part of the equity of Public Sector Undertakings (PSUs) to

private entrepreneurs (also known as Disinvestment), or
2. Withdrawal of ownership and management of the public sector companies
from the government to the private sector.
The need for privatisation was felt mainly because of the poor performance of
the Public Sector Undertakings, PSUs. As a result, the consumers were facing a
major loss, as they did not receive quality products, and other services, such as
the delivery system were also very poor. With the introduction of the
privatisation policy, this factor was eliminated as:

 Unlike PSUs, Privatisation promoted the diversification of production.

 Unlike PSUs, the Privatisation of enterprises generated higher profits.
 It also promoted customer superiority.
 Unlike PSUs, Privatisation provides high productivity.
 Unlike PSUs, Privatisation promoted growth and development by working in
a competitive environment.
Globalisation
Globalisation refers to the integration of the economy of a country with the
economies of other countries. The process of globalisation is associated with
the free flow of trade, capital across borders, increasing openness, growing
economic independence, and deepening of economic integration in the world.
The main aim of globalisation was to integrate the Indian economy with the
global economy. As a result, there will be an unrestricted flow of information,
goods and services, technologies, and even people across countries, which will
eventually enhance the development of the country. The government allowed
foreign companies to hold 51 percent or more share of the Indian companies in
the case of collaboration so that they can function freely and as the owner. This
also promoted the transfer of the latest technologies into Indian territory due to
collaboration with MNCs. The reduction of the tariff and non-tariff barriers,
adoption of policies to promote exports, increase in Foreign Investments,
increase of foreign currency in the country (Forex), growth of the IT industry in
India, and several other features came under the globalisation policy.

Impact of LPG
Positive Impacts
 Increase in GDP growth rate in India. After 1991, India’s GDP growth rate
increased year by year, and in the year 2015-16, it was estimated to be
7.5%, whereas it was only 1.1% during the year 1990-91. Because of the
privatisation, advanced foreign technology, reduction of taxes, and the
abolition of industrial licensing, there was major growth in the GDP of the
country.
 The rate of unemployment was high before the adaptation of the new
economic policy. But, in 1991, the rate of employment increased as the
MNCs started investing in India, which resulted in the new job opening, and
the requirement for employees was created. And due to the removal of the
industrial licensing, many individuals started their businesses.
 An increase in the country’s per capita income. Per capita income refers
to the average income earned by a person in a given country. In 1991, the
Per capita Income of India was ₹11,235, but in 2014-15 Per Capita Income
reached ₹85,533.
 Increase in Foreign Direct Investment from ₹408 Crores in 1991 to
₹106,693 Crores in 2015 after the introduction of the new economic reforms
of globalisation.
 Decrease in the Fiscal Deficit. A fiscal deficit refers to a situation where
the revenue generated is exceeded by the expenditures made by the
government. The fiscal deficit of India before 1991 was 8.5% of Gross
Operating Profit, but it came down to 4% of the Gross Operating Profit in
2015.
Negative Impacts
 Agriculture has been the backbone of the Indian economy but, because of
NEP, there was a decrease in the growth rate of the agricultural
sector. The agricultural sector came from giving employment to 72% of the
population in agriculture, and a contribution of 29.02% to GDP in 1991 to a
drastic fall of only 17.9% contribution to GDP in 2014.
 Reduction in employment level. Because of the strict labour laws imposed
due to the economic liberalisation in the manufacturing industries, the
employment level of the country had a downfall.
 The globalisation of the economy caused threats to local businesses and
companies. Due to the invasion of MNCs, the level of competition increased,
as the Indian market had limited finance, a lack of adequate technologies,
and inefficiency of production.
 Because of the emission of harmful gases and chemicals from
manufacturing plants and the construction of new companies, there has
been an adverse effect on the environment, which resulted in pollution
and clearing of the vegetation covers.
 The reforms focused mainly on the formal sector of the economy, thus other
sectors such as the urban informal sector, the agricultural sector, and
forest-dependent communities were untouched by the reform. As a result of
this, there was an uneven growth in the economy.

Global shocks
Global problems and shocks
The global economy faces a number of serious challenges in the 21st Century.
Globalisation has benefitted most participants, but the increasing
interconnectedness of the global economy has created a number of problems.

Short term problems

Some global problems are short term, such as the recent recession caused by
the financial crash and related banking crisis. Most global shocks are relatively
short term and may be self-correcting. Other apparently short run events can
have long lasting effects, such as the oil shocks of the 1970s, which
permanently altered the global market for oil.

Longer term problems

Other global problems are longer term, and may require a strategic approach to
finding solutions. These problems include global inequality and unequal
economic development, global poverty, the exhaustion of non-renewable
resources, depletion of the environment and global warming, and systemic
problems associated with inadequate regulation of financial markets.

A significant problem resulting from globalisation is the increased risk to

national economies from shocks over which they have little control.
Globalisation means that economies are increasingly interconnected, and
interdependent, and while this generates long term gains in terms of trade,
growth and jobs, it also presents economies with risks and challenges.

One risk is that a shock originating in one part of the world, or in one industry
or market, can quickly ripple across a country, a region, or the whole global
economy, leaving economic turmoil in its wake. By their nature, shocks are
often unexpected, but policies can be adopted which help to reduce the impact
of shocks.

Types of shock:
Temporary shocks, such as a terrorist attack, or a one-off change in a
commodity price, like a rise in wheat prices, which quickly return to the
‘normal’, long run trend.
Permanent shocks, such as an oil shock, which permanently alters the market
for motor vehicles. Some economists argue that the financial crisis of 2008-09,
and the resultant impact on the motor industry, will kick start a more carbon
neutral approach to vehicle design.
 Policy induced shocks, such as reducing interest rates or increasing
the money supply too quickly, creating an inflationary shock.
 Asymmetric shocks, which are those affecting one region or one
industry more severely than another. For example, the collapse of the
Argentinean peso on the 1990s affected Spain more than the rest of
Europe.
 Symmetric shocks, which are shocks which affect all regions or
industries in the same way.
 Financial shocks, which are those starting in the financial markets,
such as a sudden change in the exchange rate, or the collapse of a major
credit bank. See also: Banking crisis.
 Supply side shocks, which may be related to costs, such as a sudden
increase in commodity prices, or related to changes in physical supply,
such as labour strikes, or crop failures.
 Demand side shocks, which are sudden changes affecting aggregate
demand (AD), such as a collapse in consumer confidence leading to a fall
in household spending, or a sudden fall in house prices creating a
negative wealth effect.

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The Global Financial Crisis
The global financial crisis (GFC) refers to the period of extreme stress in global
financial markets and banking systems between mid 2007 and early 2009.
During the GFC, a downturn in the US housing market was a catalyst for a
financial crisis that spread from the United States to the rest of the world
through linkages in the global financial system. Many banks around the world
incurred large losses and relied on government support to avoid bankruptcy.
Millions of people lost their jobs as the major advanced economies experienced
their deepest recessions since the Great Depression in the 1930s. Recovery
from the crisis was also much slower than past recessions that were not
associated with a financial crisis.

Main Causes of the GFC

As for all financial crises, a range of factors explain the GFC and its severity,
and people are still debating the relative importance of each factor. Some of the
key aspects include:

1. Excessive risk-taking in a favourable macroeconomic environment

In the years leading up to the GFC, economic conditions in the United States
and other countries were favourable. Economic growth was strong and stable,
and rates of inflation, unemployment and interest were relatively low. In this
environment, house prices grew strongly.

Expectations that house prices would continue to rise led households, in the
United States especially, to borrow imprudently to purchase and build houses.
A similar expectation on house prices also led property developers and
households in European countries (such as Iceland, Ireland, Spain and some
 countries in Eastern Europe) to borrow excessively. Many of the mortgage
loans, especially in the United States, were for amounts close to (or even above)
the purchase price of a house. A large share of such risky borrowing was done
by investors seeking to make short-term profits by ‘flipping’ houses and by
‘subprime’ borrowers (who have higher default risks, mainly because their
income and wealth are relatively low and/or they have missed loan repayments
in the past).

Banks and other lenders were willing to make increasingly large volumes of
risky loans for a range of reasons:
 Competition increased between individual lenders to extend ever-larger
amounts of housing loans that, because of the good economic environment,
seemed to be very profitable at the time.
 Many lenders providing housing loans did not closely assess borrowers’
abilities to make loan repayments. This also reflected the widespread
presumption that favourable conditions would continue. Additionally, lenders
had little incentive to take care in their lending decisions because they did not
expect to bear any losses. Instead, they sold large amounts of loans to
investors, usually in the form of loan packages called ‘mortgage-backed
securities’ (MBS), which consisted of thousands of individual mortgage loans of
varying quality. Over time, MBS products became increasingly complex and
opaque, but continued to be rated by external agencies as if they were very
safe.
 Investors who purchased MBS products mistakenly thought that they were
buying a very low risk asset: even if some mortgage loans in the package were
not repaid, it was assumed that most loans would continue to be repaid. These
investors included large US banks, as well as foreign banks from Europe and
other economies that sought higher returns than could be achieved in their
local markets.

2. Increased borrowing by banks and investors

In the lead up to the GFC, banks and other investors in the United States and
abroad borrowed increasing amounts to expand their lending and purchase
MBS products. Borrowing money to purchase an asset (known as an increase
in leverage) magnifies potential profits but also magnifies potential losses. [ 1 ] As
a result, when house prices began to fall, banks and investors incurred large
losses because they had borrowed so much.

Additionally, banks and some investors increasingly borrowed money for very
short periods, including overnight, to purchase assets that could not be sold
quickly. Consequently, they became increasingly reliant on lenders – which
included other banks – extending new loans as existing short-term loans were
repaid.
3. Regulation and policy errors
Regulation of subprime lending and MBS products was too lax. In particular,
there was insufficient regulation of the institutions that created and sold the
complex and opaque MBS to investors. Not only were many individual
borrowers provided with loans so large that they were unlikely to be able to
repay them, but fraud was increasingly common – such as overstating a
borrower's income and over-promising investors on the safety of the MBS
products they were being sold.

In addition, as the crisis unfolded, many central banks and governments did
not fully recognise the extent to which bad loans had been extended during the
boom and the many ways in which mortgage losses were spreading through the
financial system.

How the GFC Unfolded

US house prices fell, borrowers missed repayments

The catalysts for the GFC were falling US house prices and a rising number of
borrowers unable to repay their loans. House prices in the United States
peaked around mid 2006, coinciding with a rapidly rising supply of newly built
houses in some areas. As house prices began to fall, the share of borrowers
that failed to make their loan repayments began to rise. Loan repayments were
particularly sensitive to house prices in the United States because the
proportion of US households (both owner-occupiers and investors) with large
debts had risen a lot during the boom and was higher than in other countries.

Stresses in the financial system

Stresses in the financial system first emerged clearly around mid 2007. Some
lenders and investors began to incur large losses because many of the houses
they repossessed after the borrowers missed repayments could only be sold at
prices below the loan balance. Relatedly, investors became less willing to
purchase MBS products and were actively trying to sell their holdings. As a
result, MBS prices declined, which reduced the value of MBS and thus the net
worth of MBS investors. In turn, investors who had purchased MBS with short-
term loans found it much more difficult to roll over these loans, which further
exacerbated MBS selling and declines in MBS prices.

Spillovers to other countries

As noted above, foreign banks were active participants in the US housing
market during the boom, including purchasing MBS (with short-term US dollar
funding). US banks also had substantial operations in other countries. These
interconnections provided a channel for the problems in the US housing
market to spill over to financial systems and economies in other countries.
Failure of financial firms, panic in financial markets
Financial stresses peaked following the failure of the US financial firm Lehman
Brothers in September 2008. Together with the failure or near failure of a
range of other financial firms around that time, this triggered a panic in
financial markets globally. Investors began pulling their money out of banks
and investment funds around the world as they did not know who might be
next to fail and how exposed each institution was to subprime and other
distressed loans. Consequently, financial markets became dysfunctional as
everyone tried to sell at the same time and many institutions wanting new
financing could not obtain it. Businesses also became much less willing to
invest and households less willing to spend as confidence collapsed. As a
result, the United States and some other economies fell into their deepest
recessions since the Great Depression.

Policy Responses
Until September 2008, the main policy response to the crisis came from central
banks that lowered interest rates to stimulate economic activity, which began
to slow in late 2007. However, the policy response ramped up following the
collapse of Lehman Brothers and the downturn in global growth.

Lower interest rates

Central banks lowered interest rates rapidly to very low levels (often near zero);
lent large amounts of money to banks and other institutions with good assets
that could not borrow in financial markets; and purchased a substantial
amount of financial securities to support dysfunctional markets and to
stimulate economic activity once policy interest rates were near zero (known as
‘quantitative easing’).

Increased government spending

Governments increased their spending to stimulate demand and support
employment throughout the economy; guaranteed deposits and bank bonds to
shore up confidence in financial firms; and purchased ownership stakes in
some banks and other financial firms to prevent bankruptcies that could have
exacerbated the panic in financial markets.

Although the global economy experienced its sharpest slowdown since the
Great Depression, the policy response prevented a global depression.
Nevertheless, millions of people lost their jobs, their homes and large amounts
of their wealth. Many economies also recovered much more slowly from the
GFC than previous recessions that were not associated with financial crises.
For example, the US unemployment rate only returned to pre-crisis levels in
2016, about nine years after the onset of the crisis.
Stronger oversight of financial firms
In response to the crisis, regulators strengthened their oversight of banks and
other financial institutions. Among many new global regulations, banks must
now assess more closely the risk of the loans they are providing and use more
resilient funding sources. For example, banks must now operate with lower
leverage and can’t use as many short-term loans to fund the loans that they
make to their customers. Regulators are also more vigilant about the ways in
which risks can spread throughout the financial system, and require actions to
prevent the spreading of risks.
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Demonetisation
Demonetisation is an act of cancelling the legal tender status of a currency unit
in circulation. Anticipating positive changes on the liquidity structure as a
whole, nations often adopt Demonetisation policy as a measure to
counterbalance the current economic condition. Countries across the globe
have used Demonetisation at some or the other point to control situations such
as inflation and to boost economy. In November, Indian government banned
the high denomination notes of Rs.1000 and Rs.500 as move to curb
counterfeiting and money laundering.

Effects of Demonetisation on various sections of Indian Economy

Demonetisation, that sent a shockwave across the Indian economy, completes
one month since its announcement on the midnight of November 9. To uproot
the problems of corruption, black money, and counterfeiting, Prime Minister
Narendra Modi orchestrated this master plan which has reportedly swept off a
mammoth portion of India's monetary base. It is anticipated that this surgical
strike on black money will also increase cashless transactions in the country
and untie all knots in tax collection. But on the other hand, rural households
and elder citizens have been worst hit due to the sudden monetary reform. The
decision to scrap all Rs.1000 and Rs.500 notes have made it to headlines all
over the world, attracting both positive and negative comments.

Demonetized currency and small savings schemes

Government has notified banks to not accept the discontinued currency notes
for deposit in small saving schemes. However, no reasons have been specified
for such a move by the competent authority. Small savings schemes are one of
the most sustainable financial options which provide greater returns with low
risk factor. Some of the popular savings schemes are Kisan Vikas Patra,
Sukanya Samridhi, Post Office Savings Schemes, etc. For those without access
to banks, cash transactions are the only practical means to meet their everyday
requirements and for small scale investments. The statement also mentions
that Post Office accounts have been excluded from the rule imposed on small
savings schemes.

Impact of Demonetisation on Indian economy

In a country where 85% of transactions take place by cash, cancelling the legal
tender character of two high denomination banknotes arises a lot of questions.
The service sector in the country that depends mostly on cash transactions will
be adversely hit because of Demonetisation. Not to mention, the consumption
activity of India has come to a screeching halt. This drop in economic activity
could last for a few months and as a result, GDP could fall significantly from
the previous year's values.

Even as country faces the greatest financial crunch of all times, some analysts
predict the economic conditions to stabilize in a few quarters. Deutsche bank
and Goldman Sachs expect India to join the list of the fastest growing
economies by next fiscal year. An improved monsoon season in 2017 can favor
agricultural economy of the nation, which in turn will add to the financial
recovery as a whole. Economists also predict that the decision to scrap high-
value currency notes will lead to GDP growth by 2%.

Effect of Demonetisation on bullion market

Demonetisation is expected to bring sharp changes in the prices of gold, and it
is likely to start reflecting from the first quarter of 2017. At present, gold rates
are not being announced by most of the jewelers due to dampening trade.
Recently, government also announced the exemption limits on gold ornaments
as the next giant move to curb black money. The notification comes within
weeks after invalidation of Rs.500 and Rs.1000 notes. The following restrictions
have been placed on the possession of gold:

 A married woman in India cannot keep more than 500 grams of gold in
custody
 The limits for unmarried women are 250 grams
 Male members of the family can keep only 100 grams of gold.
 The rule is not applicable for legitimate gold belongings
Effects of Demonetisation on real estate
The unorganized sector will be largely affected by the invalidation of the higher
denomination currency notes. However, there won't be much of a change in the
primary real estate market as property buyers make purchases either in the
form of cheques or through loans. The impact of Demonetisation may be felt in
secondary markets where most of the property dealings happen through cash.
The currency reform is likely to yield positive results in the real estate sector
with increased transparency in dealings. More opportunities can be expected
from debt investment, private equity, and FDIs as well.

Demonetisation impact on equity and mutual funds

The effect of Demonetisation on equity funds is expected to be positive with
more money entering the organized system of financial transactions. If cash
flow across the nation is fully tracked, equities will strengthen significantly, as
more people will invest in equity linked savings schemes to save on taxes.

Tax to GDP ratio

In an economic survey conducted last year, the tax to GDP ratio of India was
found to be at 16.6%, which is comparatively low when compared to emerging
markets across the world. But with deposits drifting away from the
unorganized zones and getting channelized to banks, the tax to GDP ratio is
expected to rise drastically. Analysts also predict a significant rise in the tax
collection percentage, as all financial transactions will be under the scanner.
Owing to the same reasons, government may also reduce tax rates.

Jan Dhan accounts

At present, the contribution of Jan Dhan accounts in terms of deposits has
been significantly low in the overall banking domain. But post Demonetisation,
these idle accounts are witnessing a steep surge in deposits. Another positive
side of the Demonetisation is that government's financial inclusion plan will
gain momentum with a large number of people—including those from rural
areas—opting for bank-based transactions.

E-wallets getting a major push

With the cancellation of Rs.500 and Rs.1000 currency notes, e-wallet
companies such as Paytm, PayU India, Mobikwik, etc. are witnessing a sudden
rise in their daily transactions. Demonetisation will also have an impact on the
hiring needs and other business functions of these companies. Even app-based
cab companies are launching their promotional materials to encourage
cashless transactions.

Pre-owned vehicles market

Sales activities in the in used vehicle market is expected to decline following
the Demonetisation move. This can adversely affect the original manufacturers
to a certain degree, as prospective buyers may not find it easy to discard their
old vehicles and go for a new one.

Effect of Demonetisation on interest rates

As a result of increased liquidity, RBI is likely to cut down the rates of interests
applicable on fixed deposits, recurring deposits, and the like. Since banks are
sure to accumulate huge deposits in the months that follow, the borrowing cost
for Banks will be reduced. This benefit will be extended to customers in the
form of lower interest rates on loan products.

Cement and steel industry

A temporary decline in sales can be observed in the cement and steel sectors
which are closely linked to real estate. A closer look at the situation reveals
sizeable impact of Demonetisation on construction industry—daily wage
earners being the worst sufferers. However, with an increase in bank deposits
complementing the savings rate, the short-term difficulties will be outstripped
soon.

Short-term effect on GDP

Reduced consumer demands owing to dulled cash flow will trigger a
considerable decline in GDP figures for a few quarters. The effect of
Demonetisation on the above-mentioned industries such as construction, gold,
and other secondary markets will be reflected in GDP. But, the situation will be
under control once cash flow is normalized in these areas of business.

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