Since independence, successive governments have attempted ambitious economic development programs with mixed results. The nationalization in 1962 of three Western oil companies and in 1975 of large rubber and tea plantations was intended to end the nation's economic dependence and neocolonialism, and to create an egalitarian socialist society. The goals of the last five-year plan for 1972–76—to achieve an economic growth rate of 6% annually, to create new jobs, and thereby to ameliorate unemployment—were not met, in part because of drought and unexpected increases in the costs of crude oil, fertilizer, and other imports.
The UNP government elected in 1977 chose as the centerpiece of its development strategy the Mahaweli hydroelectric-irrigation-resettlement program, the largest development project ever undertaken in Sri Lanka. The project involved diverting the Mahaweli Ganga in order to irrigate 364,000 hectares (900,000 acres) and generate 2,037 million kWh of hydroelectricity annually from an installed capacity of 507 Mw. Launched in 1978, construction was largely completed by 1987, at a cost of about $2 billion. Even as the UNP government launched this massive capital program, it sought to encourage private investors, limit the scope of government monopolies, and reduce subsidies on consumer products. Foreign trade, investment, and tourism were all encouraged by the government authorities. In 1986, foreign aid rose 23% in real terms over 1985, largely to finance further massive hydroelectric projects.
While government development policies resulted in moderate growth during the late 1970s and early 1980s, the outbreak of civil war in 1983 led to a rapid rise in defense spending (from 1% of GDP in 1980 to over 4% in 1996), exacerbating structural weaknesses in the Sri Lankan economy. By 1989, rapidly declining economic growth and worsening fiscal and balance of payment problems reached crisis proportions, prompting renewed stabilization and adjustment efforts. Corrective policies involved stimulating savings through new banking regulations and other monetary-tightening measures, reduction of subsidies on wheat and fertilizers, government expenditure reductions, currency devaluation, privatization of many state enterprises, and other incentives for private investment. These measures resulted in greatly improved economic performance in the early 1990s, despite unfavorable weather and the on-going insurgency.
In 1996, as the market showed signs of weakening, the government reaffirmed its free-market policies. From 1997 to 2001, however, the economy was whipsawed between a series of exogenous shocks and political pressures to maintain welfare expenditures. In 1998 the insecurity arising from the Tamil Tiger separatist campaign was aggravated by Pakistan's and India's the nuclear tests, and the aftermath of the Asian financial crisis. Recovery in 1999 and 2000 was cut short in 2001 by the global economic slowdown, the LTTE terrorist attack on the country's international airport in July, the 11 September terrorist attacks on the United States, and the onset of severe drought, all of which combined to produce Sri Lanka's first year of economic contraction on record. 2002, by contrast, was marked by hopeful developments. In February, the Norwegian-brokered ceasefire between the LTTE and the government was reached, and in May, the end of drought conditions meant the restoration of reliable power supplies, which also helped bring down agricultural prices.
Laws encompassing welfare reform, tax reform and investment deregulation were passed, and, in January 2003, the Financial Responsibility Act (FRA) was adopted setting a course to bringing the budget deficit down to below 5% of GDP by 2006, and of limiting government borrowing to less than 10% total revenue. In all, 36 new laws were introduced by the government to buttress the economy's financial stability and the government's economic program adopted for 2003–2006. The three-year program aims at the reduction of poverty through private-sector growth. The strategy focuses on creating conditions conducive to private sector growth and a sound fiscal position, and for helping establish lasting peace through relief, rehabilitation, and reconstruction (RRR). The program is being pursued in close conjunction with a three-year arrangement with the IMF under its Poverty Reduction and Growth Facility and Extended Fund Facility (PRGF/EFF) with a credit line of SDR 413.4 ($567 million) approved in April 2003. Although aiming at sustained growth of 8–10% in the long run, the medium term goal is an average 61/2% real GDP growth for 2003–06. To achieve program's objectives, government policies are focused on four areas: 1) restoring fiscal sustainability, including raising revenues by 21/2% of GDP; 2) implementing structural reforms mainly involving deregulation and privatization; 3) creating opportunities for the poor to share more fully in the benefits of economic growth through improvements in infrastructure and education; and 4) garnering resources for reconstruction, including though donor assistance and government investments.