The Middle East (ME) conflict is triggering widespread economic shockwaves across the globe, testing the resilience of every economy. According to the International Monetary Fund (IMF), world growth forecasts have declined to 3.1 per cent and 3.2 per cent in 2026 and 2027 respectively, down from 3.4 per cent in 2025. Asia is particularly vulnerable to these shocks due to its large and growing population and its heavy dependence on energy imports and reliance on oil transit through the Strait of Hormuz. Notably, South Asian countries are experiencing severe price hikes in oil and oil-related products and services, which are significantly disrupting transport and logistics systems, and maritime trade. As a result, widening trade deficits contribute to currency depreciation.
The announcement of foreign exchange outflow restrictions by Indian Prime Minister Narendra Modi, including measures such as discouraging non-essential foreign travel, destination weddings abroad, and the use of imported products, signals that Sri Lanka may feel the spill over effects of these policies. India is Sri Lanka’s second-largest trading partner, with annual exports amounting to approximately US$ 883 m and imports reaching $ 3.7 b (2024). Moreover, restrictions on foreign travel could negatively affect Sri Lanka’s tourism earnings, as Indian tourists account for nearly 27 per cent of total tourist arrivals. Nevertheless, deeper Sri Lanka India trade integration, particularly in port development and energy connectivity, may create long-term investment opportunities and strengthen regional energy security.
Sri Lanka has already been experiencing a triple shock. First, the economic crisis that led the country to default in 2022; second, Cyclone Ditwah, which caused significant infrastructure damage with estimated rebuilding costs of approximately $ 4.1 b in 2025; and third, the ongoing ME conflict, which is testing the resilience of the economic foundation established under the 17th IMF programme. With a relatively small economy and a gross domestic product of around $ 108.8 b, Sri Lanka remains highly vulnerable to external shocks.
In contrast, Sri Lanka is in a better position than it was in 2022. Foreign reserves have increased to $ 6.8 b, including $ 1.4 b in currency swaps from the People’s Bank of China. Therefore, the actual usable reserves amount to $ 5.4 b, equivalent to about two months of imports. However, soaring global oil prices leave limited room to absorb external shocks, and their impact on Sri Lanka is inevitable. The widening trade deficit and the fragile balance of payments continue to exert mounting pressure on foreign exchange reserves.
Sri Lanka’s export basket remains limited and heavily concentrated in a few sectors. Garment exports to the US amount to approximately $ 2.9 b out of $ 5.3 b, while tea exports generate around $ 1.5 b, of which nearly $ 700 m, approximately 45 per cent of total tea exports, is accounted for by the ME market. In addition, tourism earnings are about $ 3.2 b, while workers’ remittances contribute approximately $ eight b. Meanwhile, the country’s tiny economy must finance imports worth nearly $ 21.5 b annually.
Although the depreciation of the Sri Lankan Rupee may provide benefits to exporters in the short term, the rising cost of exports remains a major challenge. Increasing global oil prices and the need for longer alternative shipping routes due to the potential closure of the Strait of Hormuz have sharply increased costs related to maritime transport, air freight, domestic transport and logistics, as well as insurance premiums.
Sri Lanka is heavily dependent on imports, including raw materials for the garment industry, essential food items, and particularly fertiliser, which is critical for the agricultural sector. Consequently, the trade deficit continues to widen while the demand for foreign exchange increases sharply. Restricting foreign exchange outflows by reducing imports of luxury goods may help support the appreciation of the Rupee in the short term. However, inflation driven by supply-side pressures places additional strain on the domestic price stability. Furthermore, unfavourable market sentiment may discourage foreign investment inflows and weaken investor confidence in the equity market.
It is imperative that Sri Lanka follows market-based price signals, particularly for energy products, in order to balance the demand and supply effectively. However, such measures may adversely affect poor and vulnerable communities. The poverty rate remains at approximately 24 per cent based on the purchasing power parity $ 3.65 threshold, meaning that nearly one-fourth of the population lives in poverty. Rising inflation would disproportionately affect low-income households and vulnerable groups. Therefore, targeted cash transfer programmes are essential, alongside measures to enhance agriculture production and ensure food security, particularly if the ongoing ME conflict continues to prolong.
India experienced a similarly devastating situation during the First Gulf War due to insufficient foreign reserves. However, the effective implementation of liberalisation, privatisation, and globalisation policies played a pivotal role in transforming the economy. As a result, India emerged as one of the leading emerging economies and became an attractive destination for multinational corporations and foreign investment.
Trade reform is not a choice for Sri Lanka; it is significant for a long-term economic growth. A strategic approach is required to attract sustainable, labour-intensive foreign direct investment, enhance exports, and build a resilient economy capable of withstanding external shocks and vulnerabilities. Sri Lanka cannot afford another fiscal or balance of payment crisis, Therefore, gradual but consistent progress in capital infusion, export diversification, and structural reforms is essential to reduce long-term pressure on foreign exchange reserves and ensure sustainable economic stability.
The writer is an Economist, visiting Researcher at the Centre for Poverty Analysis
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The views and opinions expressed in this column are those of the author, and do not necessarily reflect those of this publication