Sri Lanka is the first South Asian nation to adopt, rather fully, the liberal outward-looking policies. It has brought in series of changes in its trade regime since it gained independence from British colonial rule in 1948. During the first decade after independence, it continued with a liberal trade regime.
However, growing BOP problems and change in political leadership induced a policy shift-towards protectionist import substitution policies. By the mid- 1970s the Sri Lankan economy had become one of the most inward-oriented and regulated economies.
The fall-out of these polices was the slowing down of the economic growth since the early 1960. In the latter half of the 1970s, the government, therefore, decided to embark upon the path of extensive economic liberalisation. It launched SAPs in two phases, first in 1977-89 and second in 1990 and onwards.
The First Phase (1977-89)
The process of economic reforms began in late 1977 first by initiating the task °f revising tariff structure, reducing restrictions on foreign investment, Enouncing new incentives to export-oriented foreign investment under a Free Trade Zone scheme.
It also undertook financial reforms including adjusting interest rates to levels above the rate of inflation, opening the banking sector to foreign banks and allowing credit markets to determine interest rates, exchange rate realignment and incentives for non-traditional exports.
It devalued its domestic currency by more than 100 per cent (in nominal terms). The impact of these reforms on the economy was quite substantial as the GDP growth rate went up from 2.9 per cent in the first half of the 1970s to 6 per cent during 1978- 83 The FDI inflows which were US$0.2 million in 1970-77 reached to about US $41 million in 1978-87 . The exports went up to US$1.5 billion in 1988 from US $0.80 billion in 1977.
Most importantly the confidence of the foreign investors increased and number of joint ventures between domestic and foreign investors increased. However, these reforms lost ‘momentum in the early 1980s mainly because of two reasons: first shift in policy priorities away from structural adjustment towards politically appealing glamorous investment projects and secondly, the intensification of the ethnic conflict between the Sri Lankan Tamil and the government forces.
The Second Phase of SAPs (1990 onwards)
The movement for separate land for the Sri Lankan Tamil picked up around mid-1980s under the banner of Liberation Tigers of Tamil Eelam (LTTE) which caused immense economic loss and instability in political and social fields.
The LTTE’s revolt and militant activities resulted in sharp escalation in defense expenditure, which, in turn led to widening Fiscal deficits, growing macroeconomic problems, and a rapid erosion of international competitiveness. By the end of 1988, the forex reserves had fallen sharply. The FDI declined and there was balance of payments crisis which compelled the government to approach the IMF in June 1987 for financial support. The loan was sanctioned with the conditionality of launching economic reforms. The reform package included privatisation programmes, further tariff cuts and simplification, removal of exchange controls on current account transactions (of BOPS), commitment to flexible exchange rate, and an initiative to cut the fiscal deficit. The implementation of reforms package helped the economy to rejuvenate growth rate from 3.5% in the latter half of the 1980s to 5.03 per cent in the first half of the 1990s.
The containment of the LTTE’s rebellion (for a while) during 1990-96 also helped the government to make concerted efforts to refocus attention on developmental activities. With the return of social stability and peace, the foreign investment began flowing in the country. In 1997, the FDI inflows rose to US$433 million. There was also marked improvement in exports. However, the question of reducing military expenditure could not be resolved. The country spends over 4 per cent of national income on military which is quite high for a modest economy like Sri Lanka.