The role of government in the economy during the final decades of British colonial rule was considerable. The plantation economy required extensive infrastructure the colonial state developed and owned railroad, electrical, postal, telegraphic, telephone, and water supply services. Quasi-state finanÍÍÍÍcial institutions served the colony's commercial needs, and during World War II the government set up production units for plywood, quinine, drugs, leather, coir, paper, ceramics, acetic acid, glass, and steel. Welfare policies also began during colonial rule, including a network for free and subsidized rice and flour established in 1942. Free education, relief for the poor, and subsidized medical care were introduced in the late British period. Moreover, after 1935 the government took an active role in the planning and subsidizing of colonization schemes. This policy was designed to remove landless peasants from heavily populated areas to newly irrigated tracts in the dry zone.

Economic policy since Independence is divided into two periods. During the first, which lasted from 1948 to 1977, government intervention was often seen as the solution to economic problems. The expansion of government participation in the economy was fairly steady, resulting in a tightly regulated system. This trend was especially marked during the period of S.R.D. Bandaranaike's second government, from 1970 to 1977, when the state came to dominate international trade and payments the plantation, financial, and industrial manufacturing sectors and the major trade unions outside the plantation sector. It also played a major role in the domestic wholesale and retail trade.

The trend toward greater government involvement was largely a response to the deteriorating terms of trade. The plantation economy had financed social programs such as subsidized food in the late colonial period, but when the value of exports declined after 1957, the economy's capacity to support these programs was strained. When the foreign exchange reserves of the early 1950s dwindled, import-substituting industrialization was seen as a solution. Because the private sector viewed industrial development as risky, the government took up the slack. When balance of payment deficits became chronic, some nationalizations were justified by the need to stem the drain of foreign exchange. Similar concerns led to the tighter regulation of private business and the establishment of state-owned trading corporations. When there were shortages of necessities, governments expanded state control over their distribution in order to make them available at low prices.

The 1977 elections were largely a referendum on the perceived failures of the closed economy. The UNP, which supported a deregulated, open economy, won decisively. The new government rejected the economic policies that had evolved over the previous twenty years. Some observers believed that the economy had been shackled by excessive regulation, an excess of consumption expenditure over investment, and wasteful state enterprises. Under the UNP, market forces were to play a greater bf4 role inin allocating resources, and state enterprises were to compete with the private sector (see The United National Party Returns to Power , ch. 1).

The main elements of the new policy were investment incentives for foreign and domestic capital, a shift in the composition of public spending from subsidies to infrastructure investment, and a liberalized international trade policy designed to encourage export-led growth. Employment creation was a central objective, both through encouragement of domestic and foreign capital investment, and through an ambitious public works program, including the Accelerated Mahaweli Program, which aimed to bring new land under irrigation and substantially increase hydroelectric generating capacity (see Government Policies , this ch.). Two other policies that sought to create employment were the establishment of investment promotion zones (free trade zones) and extensive government investment in housing.

The role of government during the decade after 1977 remained significant the public investment program, for instance, was implemented on a greater scale than anything attempted previously, and in early 1988 the state remained heavily involved in many areas of economic activity. But while the government increased its efforts to develop the nation's infrastructure, it reduced its role in regulation, commerce, and production. Its initiatives received the enthusiastic support of the international development community. As a result, Sri Lanka received generous amounts of foreign aid to finance its post-1977 development program. This foreign assistance was integral to the government's economic strategy. Because budget deficits were large even before 1977, external financial resources were necessary to pay for the increased spending on infrastructure and to make up for the revenue lost as a result of the tax incentives given business. Similarly, relaxing import controls put pressure on the balance of payments, which could be relieved only with the help of foreign aid.

Data as of October 1988