The move has thrown doubts on a peace process with Tamil rebels that had sown the seeds for an economic boom.
Tourism and investment officials said the clash between President Chandrika Kumaratunga and Prime Minister Ranil Wickremesinghe would hit the island's economy by spreading uncertainty over a 20-month ceasefire with the Tamil Tigers.
The stock market had been among the world's strongest this year before Kumaratunga's action on Tuesday, which included the sacking of three ministers.
Wickremesinghe said the moves were aimed at undermining a peace process with the Tigers.
"If the uncertainty prevails the market will have to re-rate downwards," said Sheyantha Abeykoon, an investment analyst at Eagle NDB Fund Management, which owns close to two billion rupees ($20.9 million) in stocks. "It will hit profits, especially in tourism, this quarter."
Optimism over the economy, which the central bank had forecast would grow as much as 6% six this year and 6.5% in 2004, had driven the market up 70% in 2003 through Monday. But a 5% fall on Tuesday and Wednesday's tumble cut its gain for the year to 42.47%.
Kumaratunga sacked three ministers
and declared state of emergency
The key Colombo all-share index closed down 12.98%, or 173.25 points, at 1,161.29, in trade worth one billion rupees. It was the lowest close since September 17.
Sri Lanka Telecom Ltd, the largest stock, slumped 23% to 19.25 rupees.
Wednesday's fall wiped 39 billion rupees off the value of the market. The rupee fell 40 cents to 95.60 per dollar, but the bond market saw little trade. After the markets closed, the president declared a state of emergency.
"It's panic mode," said Naren Godamunne, a broker at DFCC Stockbrokers.
But Central Bank Governor, Amarananda Jayawardene, said there was no reason for panic.
"Economic fundamentals have not changed," he said, playing down the impact of tourism on the economy.
Some investors saw the slide as a buying opportunity: foreigners bought 138 million rupees of stocks and sold just 23 million's worth, though foreign holdings in stocks have dipped marginally this year.
Nalin Gunasekera, a 35-year-old investor standing in the hall of the Colombo Stock Exchange watching an electronic ticker, said he was looking to buy cheap.
"Everyone is afraid to buy stocks," he said, surveying the funereal atmosphere on the trading floor. "I think it will recover."
Others were less optimistic. A tourism official said visitors might cancel trips planned for November and December.
Tourist arrivals rose 21% to 338,000 in the first nine months of 2003 compared with the year-earlier period.
Mohan Thangarajah, an official at Mast Industries Ltd, a top garment exporter, said foreign buyers had called off a visit to the island.
"If it drags on there will be an impact," said Arjunna Mahendran, the head of the Board of Investment, the government's investment promotion body.
The government had been expecting foreign investment to rise to a record $300 million in 2002, up from $242 million last year. (US$1 = 95.60 rupees)