In 1977, the newly elected UNP government of J.R. Jayewardene initiated a landmark change in the direction of Sri Lanka's economic policies. After almost four decades of the steady expansion of state welfare provision, and of the heavy regulation of private sector economic activity, Jayewardene inaugurated a risky and radical programme of market liberalisation. Sri Lanka was one of the first countries in the developing world – after Chile and Indonesia – to embrace market liberalisation, and soon enjoyed the benefits of a wave of foreign aid by western donors who were eager for these to be seen to succeed. In the first two years of the reforms, the UNP deregulated foreign trade, removed import controls, devalued the exchange rate by 43 percent, eliminated subsidies on food and petrol, liberalised internal agricultural markets, reduced export duties, encouraged foreign investment, established export processing zones, modified labour legislation, and deregulated credit markets (Athukorala and Jayasuriya 1994, Jayewardene et al 1987, Stern 1984, White and Wignaraja 1992, Herring 1987).

The economic reform period, and the aftermath of the 1977 elections also witnessed a paradoxical escalation in the island's ethnic conflict. After three decades of pursuing federalism through parliamentary means, the centre of gravity of Tamil political activity was shifting decisively in the direction of separatism in terms of its goals, and militancy in terms of methods. The 1977 elections had led to the ascendancy of the Tamil United Liberation Front (TULF), an umbrella organisation formed largely out of the old Federal Party (FP), which had contested and won a decisive share of the Tamil vote on the basis of an explicitly separatist platform. Over the period 1977–83, the Colombo-based parliamentary leaders of the TULF were overtaken and eclipsed by the Jaffna-based militant youth groups that they had earlier patronised and presumed to control.

It had long been supposed by the UNP leadership of that time that faster economic growth, and a reduction in youth unemployment would help to address the economic drivers of the ethnic conflict. For a combination of economic and social-cultural factors, the UNP's traditional support base in the business community has been the segment of society least invested in the logic of Sinhala nationalism, and most interested in bringing a quick end to the ethnic conflict.