Since 1977, the Sri Lankan economy, once dominated by agricultural, has experienced strong growth in its industrial and services sectors. While annual growth in agricultural output averaged only 2% between 1988 and 1998, industry and services expanded at annual rates of 7.1% and 5.4%, respectively. From 1988 to 2000, agriculture's share of GDP declined from 26.3% to 21%, although employing still about 35% of the labor force. Overall, real GDP has grown at an average annual rate of 5.2% 1991 to 2000.
Economic expansion has been led by manufactures, particularly textiles and apparel, which is also the leading net earner of foreign exchange. In 1998, the manufacturing sector grew 6.3%, only 4.4% in 1999, and then surged ahead 9.2% in 2000. The textile sector grew 16.25% in 2000 (up from 7.5% in 1999), which in turn contributed to a 20% growth in exports. Services, accounting from 54% of GDP in 2000, grew by 4.7% in 1999 and 6.9% in 2000, led by tourism, the second-largest foreign exchange earner. Overall Sri Lanka experienced strong 6% growth in 2000, compared with 4.7% in 1998 and 4.3% in 1999. However, imports of goods and services increased even faster than exports, and the current account deficit jumped to6.6% of GDP from 3.7% in 1999. The government responded with several devaluations of the rupee, and then on 23 January 2001 switched to a flexible exchange rate system. Inflation, which had been held to 4% in 1999 as measured by the Colombo Consumer Price Index (CPI), rose to nearly 11% in 2001. In April 2001 the government entered into a 14-month stand-by arrangement with the IMF to stabilize the economy.
In the meantime, external and internal events combined to produce a decline in real GDP of 1.5% in 2001, the first annual contraction ever recorded for Sri Lanka's economy. The global economic slowdown from the beginning of 2001 reduced export demand, which fell nearly 13%; the attack on Colombo's international airport in July by the Liberation Tigers of Tamil Eelam (LTTE) sent tourism plummeting with war risk surcharges applied to aircraft and shipping; a severe drought reduced agricultural and hydroelectric output; and the 11 September 2001 terrorist attacks on the United States added the effects of a sharp world-wide reduction in foreign direct investment to contractions in travel and spending. Domestic demand was also sharply contracted, and, aided by a temporary 40% import surcharge aimed at maintaining foreign exchange reserves by discouraging imports, the current account deficit fell to 1.9% of GNP, an ironic note of improvement. Unemployment swelled, particularly in the textile and tourist industries, as did the government's budget deficit, which reached 10.9% of GDP, reflecting in part political resistance to the austerity measures prescribed under the IMF stand-by arrangement. In December 2001 the IMF suspended the arrangement.
In 2002 Sri Lanka experienced a return to real growth of between 1% to 2% due in large part to the Norwegian-brokered cease-fire agreement reached in February between the government and the LTTE, ending, it was hoped, 19 years of violent insurgency and reprisals. Revived consumer and business confidence was reflected in increases in domestic demand and tourism. The drought also eased, bringing down agricultural prices, and, as of May 2002, ending power shortages. The current account deficit remained unchanged at 1.9% of GDP as continued weak demand for commodity exports was compensated for by increased tourist receipts and remittances from abroad. The fiscal deficit fell to 8.9%, an improvement but above the government's 8.5% target. Forecasts are for about 5% growth in 2003, provided the peace process continues to move forward, structural reforms are implemented and fiscal targets are achieved.
From 1973 to 1977, the channeling of resources into social welfare programs, combined with high oil prices and frequent droughts, helped depress the economy and business growth. In 1977, the new UNP government lifted most price controls, shifted government spending into capital investment, liberalized foreign exchange and import restrictions, and eliminated some government monopolies to permit more business competition. These policies help raise the average annual increase in real GDP to 6% 1978 to 1981, compared to 3% 1971 to 1977. However, coinciding with the second oil shock 1978–79, a high level of inflation accompanied the increased growth. From 1980 to 1985, though exports continued to grow at an average 20% a year, real GDP growth slowed to an average 4.7% a year. In 1983, countrywide riots that left nearly 400 dead and 79,000 homeless signaled the beginning of what proved to be 19 years of separatist violence by the Tamil Tigers. In the latter half of the 1980s, the national economy was faced with grave challenges: escalating defense expenditures to combat the insurgency; recurrent drought; depressed world prices for major export crops, tea and coconut-based goods; and stagnant government revenues. These conditions produced a resurgence of inflation, increasing unemployment, critical current account deficits and stagnating economic growth. By 1989, GDP growth had fallen to 2% (down from 2.8% in 1988) while annual export growth fell to 5% and the official unemployment rate reached 18%. Worsening economic indicators spurred renewed stabilization and structural adjustment efforts by the government with emphases on tightened monetary and fiscal policies, and privatization to stimulate investment.
In the 1990s average economic growth rebounded to above 5% led, as noted, by expansions in manufactures and services. As was true for much of the rest of the world strong growth in 2000 foundered in 2001, with only a moderate recovery in 2002. The IMF currently projects real GDP growth for Sri Lanka at 5.5% in 2003 with inflation reduced to 7% from 11.3% in 2002.