Aura of prosperity masks Sri Lanka's economic decline. Once-model economy hard hit by costs of ethnic war, low commodity prices, drop in aid

Situated miles away from the Tamil guerrilla insurgency, this picturesque seaside capital along the Indian Ocean has a languid air of economic well-being. In contrast to the overcrowded and dirty cities in the nearby Indian subcontinent, Colombo combines an old-world charm with new-world amenities -- modern cars, luxury hotels, shopping areas, plush residential homes.

But the aura of prosperity is deceiving.

Not too long ago, Sri Lanka was gearing itself to become Asia's next Singapore. Following President Junius Jayewardene's election in 1977, the country set out on a course of economic development that was to make it a model for third-world countries.

But now Sri Lanka is struggling to keep its economy alive. The country's ambitions have been thwarted by the sharp escalation of the Tamil-Sinhalese ethnic conflict in the past three years which has claimed an estimated 4,500 lives. The Tamils, who make up 18 percent of the nation's 16 million people, have been fighting to establish an independent state in the northern and eastern parts of the island where they predominate. More than 4,500 people have been killed in the three-year-old conflict in this island nation off southern India.

Economists, academics, and businessmen warn that peace negotiations -- which are currently in recess -- are absolutely critical for Sri Lanka politically and economically. ``If nothing happens now, the situation will quickly deteriorate,'' a Western diplomat says.

``Economic activity has slowed down because the government is too busy doing other things, like fighting a war,'' a Western economist says.

Defense expenditures, which have tripled since 1983 to more than $350 million, are taking up an increasingly large portion of the country's gross national product which was an estimated $5.3 billion in 1984. As a result, the budget deficit has soared. Bomb attacks in Colombo last May have hurt foreign investment and tourism.

``If the war ended tomorrow, it would take 10 years to restore the economy,'' says Finance Minister Ronnie de Mel. One of the most outspoken doves in the Cabinet, Mr. de Mel said in a recent interview that the chances of success in the current negotiations are ``very good.'' ``Everyone is tired of civil war and they want peace.''

Sri Lanka's economic decline is one of the major reasons why President Jayewardene seems anxious for a political solution, analysts say. The fall in foreign investment has been a tremendous setback for his government.

After 1977, Jayewardene moved to dismantle Sri Lanka's welfare-oriented, protected economy. He set up a free-market economy in which imports are readily available. To diversify exports away from traditional commodities such as tea, rubber, and coconut, his government offered incentives to foreign investors.

The results were dramatic in the early years, economists say. GNP growth rose from an average of 3 percent in previous years to more than 6 percent annually. Construction boomed, investment rose, and unemployment dropped. By late 1983, the country had attracted about 250 export ventures to its export processing zones.

``We're still getting foreign investment proposals,'' de Mel says, ``but only at a rate of five per month compared with 10 per month last year, or 30 to 40 in 1982.''

As the world's second largest tea exporter, Sri Lanka reaped the benefits of high world prices in 1984. Last year, however, tea prices dropped by 26 percent, rubber by 23 percent, and coconut by 49 percent. This year commodity prices are slightly better, says de Mel. But this isn't to say they're on the road to recovery. Tourism also has been devastated, with a 40 percent drop since the escalation of violence since 1983.

Analysts say that most upper- and midddle-class Colombans support proposals for a peaceful solution. ``They want to get back to the business of making money,'' a government official says.

For the poorer masses, the cost of living has risen as subsidies have dropped. The government says it has kept a lid on inflation, but analysts question the accuracy of government figures. They project double-digit inflation this year, as well as an uncertain supply of some foodstuffs which come from areas affected by the ethnic war and bad weather conditions.

Part of the problem is out of Sri Lanka's control: the decline in aid from foreign governments and international agencies. The country was badly shaken by a United States decision in June to cut aid to Sri Lanka from $50 million in 1986 to $39 million in 1987.

Despite indications that even top military brass acknowledge the impracticability of a military solution, Jayewardene still holds out the threat of an all-out military campaign if peace talks collapse.

The question is, how much longer can the economy bear the burdens of higher defense expenditures? Even if a political agreement is concluded, the economy will take time to reconstruct itself.

``It'll take at least two years to change perceptions alone,'' one Western diplomat says. ``Sri Lanka will take a long time to repair the damage to its image.''