With signs of Sri Lanka anticipating an El Niño phase in late 2026, severe downside risks for the economy include food inflation projected to reach double digits for a period of 24 months, based on the previous phase's impact documented in 2015-2016, First Capital Research said in its latest economic update report.

Based on the World Bank's NOAA Climate Prediction Centre (CPC) forecast for the year, the research unit said: "Early indicators point to an emerging El Niño phase in 2026... The cycle is expected to strengthen through late 2026, with peak intensity from Q4 2026 to early 2027. Early comparisons suggest similarities to the 2015-2016 event, raising risks of comparable climate disruption."

In the case that the weather conditions are to reach a severe situation, the research unit projected that food inflation is likely to hit 10% to 12% in year-on-year growth levels, with the possibility of the growth persisting for at least 24 months.

"Food inflation is projected to hit +10-12% YoY (late-2026-2027), with a total persistence of around 24 months."

On the lower end of risks, if the culmination of the weather conditions are less severe, Sri Lanka's food inflation has the likelihood of increasing by 5% to 7% in year-on-year growth, with a chance of it lasting for 12 to 18 months.

"Moderate El Niño: Food inflation is projected at +5-7% Y-o-Y (late-2026-2027), persisting for 12-18 months."

The unit explained that it calculated the risk by overlaying the previous path of inflation charted when Sri Lanka experienced the impact of El Niño in 2016. In the overall sense, the unit found that the weather conditions contribute to macroeconomic pressures.

"We incorporate El Niño risk by overlaying the 2015-2016 realised inflation impact onto the current baseline path. Overall, a possible El Niño skews inflation outcomes to the upside, which reinforces persistent macro pressures."

Addressing Sri Lanka's trade balance, the unit anticipates that the intensification of the weather conditions will lead to weakened agricultural exports and a rise in food imports to meet local demand. Furthermore, it states that as hydro power generation output is expected to decline as reservoir levels weaken, thermal generation dependency is set to increase, raising import and cost pressures, and thereby widening the trade deficit.

"The trade balance remains as a key channel through which El Niño shocks materialise... The initial impact is observed in agriculture exports, which weaken... This is followed by a rise in food imports to offset domestic supply shortfalls... Subsequently, increased reliance on thermal energy drives higher fuel imports, compounding trade pressures."

On the impact faced by the banking sector previously, the unit found that the impact seen by El Niño on the sector was not evident immediately, with Non-Performing Loans (NPLs) rising with a delay from early 2017.

"The banking sector acts as a lagging transmission channel with impacts materialising through asset quality deterioration. The previous cycle shows that NPLs rising happened with a delay from early 2017... While Agri loan defaults are not available, banks have explicitly noted climate change, drought, and flood impacts on agriculture as a driver of rising NPLs, especially in microfinance arms and the SME books."

The unit also noted that during Sri Lanka's previous El Niño phase, supply shocks added to price pressures, thereby prompting the Central Bank of Sri Lanka (CBSL) to raise its policy rates by 100 to 125 basis points.

"The 2015-2016 El Niño-driven supply shocks pushed inflation higher, prompting the Central Bank of Sri Lanka (CBSL) to raise policy rates by 100-125 basis points... A potential 2026 El Niño cycle could reintroduce similar supply-side pressures, posing upside risks to inflation and constraining policy flexibility."

During the 2015-2016 El Niño phase, paddy production fell by about 50% from peak levels. Headline inflation, as measured by the CCPI, increased from around 2% to 8% over 24 months, and government spending rose temporarily, peaking in 2016 due to large-scale intervention.