ECONOMIC OUTLOOK

MIDDLE EAST CONFLICT A STRESS TEST

There are serious questions about whether Sri Lanka’s fragile economic revival will hold Shiran Fernando assesses the looming risks

For a small import dependent economy that’s emerging from many crises, geopolitical disruptions – particularly in energy and trade corridors – pose immediate and cascading risks.

While Sri Lanka is in a considerably stronger position today than during the onset of the Russia-Ukraine war in 2022, the current situation underscores a familiar reality: global shocks transmit quickly and disproportionately to fragile economies.

Unlike larger economies that can absorb volatility, Sri Lanka remains highly exposed not only to oil prices but also critical imports such as fertiliser and intermediate goods that transit through strategic chokepoints like the Strait of Hormuz.

The key question is not whether Sri Lanka will be affected but how severe and prolonged the impact will be.

THE FUEL BILL There’s renewed pressure on external balances. Sri Lanka’s fuel import bill is one of the most immediate transmission channels of the crisis. Any sustained increase in world oil prices or disruption to shipping routes in the Gulf region will widen the import bill and put pressure on the current account.

Even with improved reserves and a more flexible exchange rate regime, a sharp spike in prices could increase the cost of power generation and transport. This will reignite inflationary pressures and lead to renewed stress on foreign exchange liquidity.

In 2022, Sri Lanka faced acute shortages due to both price shocks and a lack of reserves. However, though the buffers are stronger today, they aren’t immune to shocks; and a prolonged conflict could once again force difficult policy trade-offs between price passthrough, subsidies and fiscal consolidation.

FOOD SECURITY Sri Lanka’s agriculture sector also remains highly sensitive to global supply chain fluctuations – particularly fertiliser imports since a significant portion of it is linked to Middle Eastern production and shipping routes.

Disruptions could manifest through higher prices, delays in supply chains and reduced application rates by farmers due to affordability constraints.

This situation risks undermining agricultural productivity at a time when domestic food security and rural incomes are still recovering.

The experience of recent years has already demonstrated how input shocks can quickly translate into lower yields and higher food inflation. Sri Lanka needs to secure fertiliser for the next few seasons at the earliest.

REMITTANCES Foreign worker remittances provide a critical but uncertain buffer. It comprises Sri Lanka’s most vital source of foreign exchange and could face mixed effects.

On the one hand, Middle Eastern economies may benefit from higher oil prices, and potentially sustain employment and incomes for Sri Lankan migrant workers.

However, geopolitical instability could disrupt labour markets in some countries, delay payments or reduce demand for foreign workers in affected regions – and this could create uncertainty for new migration flows.

Since a substantial portion of Sri Lanka’s overseas remittances originate from the Gulf, any prolonged instability will introduce downside risks to what has been a key pillar of external sector recovery.

CLEAR POLICIES Sri Lanka’s recent macroeconomic gains – which include a primary account surplus, a current account improvement and an accumulation of reserves – provide a cushion.

However, these gains remain fragile and come at a time when maintaining reform momentum and debt sustainability is critical. Any deviation risks undermining investor confidence and delaying the recovery.

If there is one clear takeaway from repeated global shocks, it is that Sri Lanka can’t afford to remain structurally exposed. The current crisis reinforces the urgency of accelerating reforms in several key areas as follows.

ENERGY Energy security, diversification and reduced dependency on imported fossil fuels must be a national priority. This includes scaling up renewable energy sources (e.g. solar, wind and hydro) through battery storage, strengthening grid stability and storage capacity, and encouraging private sector participation in energy generation.

REFINERY Sri Lanka’s outdated refinery limits its ability to optimise fuel imports and manage price volatility. Upgrading refining capacity and expanding strategic fuel storage will improve supply resilience, enable better timing of imports and reduce vulnerability to short-term disruptions.

AGRICULTURE The development of more resilient fertiliser supply chains including the diversification of sourcing and potential local blending can reduce exposure to external shocks.

DIVERSIFICATION Reducing reliance on a narrow set of markets for remittances and exports will be key. Expanding economic linkages beyond traditional partners can provide greater stability.

STABILITY Though stability has been achieved, the situation isn’t secure. Though Sri Lanka has made notable progress since its economic crisis, the Middle East conflict is a timely reminder that stability is still not assured. The country’s resilience will ultimately depend not only on short-term buffers but also the speed and depth of structural reforms.

External shocks are inevitable but their impact need not be. Policy makers must act decisively to reduce vulnerabilities or risk being tested again when the next global shock arrives.