The onset of the Gulf crisis has undoubtedly stifled the overall investment sentiment in Sri Lanka, with experts expressing varying views on how the current crisis, on top of the remnants of the 2022 economic crisis, impacts Sri Lanka’s overall investment climate.
Soon after the attack on Iran was launched, Sri Lanka’s thriving stock market suffered a blow. By 20 March, the bourse had plunged 12.7%, while the All Share Price Index (ASPI) closed up 1.85%, or 375.72 points, at 20,639.73.
Explaining the country’s recovery from the 2022 crisis, First Capital Holdings Assistant Vice President – Research Ranjan Ranatunga told The Sunday Morning Business that Sri Lanka had experienced a recovery following 2022, with its Gross Domestic Product (GDP) having returned to 2020 levels by the end of last year.
He explained that in terms of the investment climate, the ASPI had peaked at 14,000 in January 2022 prior to the crisis, before falling to around 7,000 levels during the crisis. Ranatunga added that the ASPI had since recovered to around 21,000–22,000 levels after reaching a peak of 24,000, reflecting growth.
He attributed the growth to low interest rates – a key driver of the ASPI – along with improved profitability of listed corporates. He also stated that factors such as political stability, reform continuity, and improved market sentiment had contributed positively. According to Ranatunga, Sri Lanka had moved past the post-2022 recovery phase and returned to levels seen before the crisis.
Impact on SL’s external position
However, commenting on the external shock stemming from the Middle East crisis, Ranatunga noted that Sri Lanka remained vulnerable due to its import-dependent economy, explaining that when oil prices rose, the country’s import bill also increased. He further explained that since the current conflict was in the Middle East, remittances could also be affected.
Ranatunga warned that this could affect livelihoods and potentially lead to a slowdown in remittances in the coming months if the situation were to persist.
He further explained that exports could also be affected, noting that with rising oil prices, institutions such as the Asian Development Bank (ADB), World Bank, and International Monetary Fund (IMF) had been slowing down global growth rates, which could weigh on export performance. He added that exporters and markets that Sri Lanka catered to may also face constraints, which could lead to a decline in export demand.
Ranatunga also noted the impact on the tourism sector, since Sri Lanka’s main tourism markets currently include India, Russia, and Europe, with Europe being a significant market. Many flights from Europe transit through Middle Eastern hubs, and disruptions to these routes have forced airlines to reroute flights, increasing airfares and affecting tourist arrivals.
He explained that declining tourism earnings, potential impact on remittances, slower exports, and rising imports would impact Sri Lanka’s external position – specifically the Balance of Payments (BOP) – meaning that the Central Bank of Sri Lanka’s (CBSL) ability to purchase dollars will also be reduced. This, in turn, could influence economic growth and investor sentiment.
“People have taken these developments into consideration and investors are reducing their positions in order to reduce exposure to equities. This is why we saw that with the conflict arising, the ASPI declined by around 15%. Concerns over the impact on corporate earnings and profitability also contributed to this trend,” he said.
Looking ahead, he stated that if the conflict continued, a further decline of the ASPI would be seen. However, he noted that recent discussions around a possible ceasefire had supported investor sentiment, indicating that such developments were being viewed positively by investors.
Global economic transition
When discussing investment, it is important to distinguish between financial market investments and direct investments. Financial market investments include portfolio investments that flow into bonds, bills, other fixed-income instruments, and equities, while direct investments or Foreign Direct Investment (FDI) refer to longer-term investments that contribute to structural changes in an economy.
Speaking to The Sunday Morning Business, Frontier Research Head of Macroeconomic Advisory Chayu Damsinghe noted that any global shock, including the current one, would primarily be transmitted through portfolio investment channels. He explained that in most countries, the immediate impact of global uncertainty was seen when funds moved out of countries during periods of heightened risk and returned once conditions improved.
However, he pointed out since around 2017–2018, foreign participation in Sri Lanka’s financial markets had remained very low. As a result, he explained that despite global shocks, there was limited foreign capital that could exit Sri Lanka, which in turn limited such impact. He added that in terms of FDIs, the current situation did not create a significant fundamental change in the short term.
“In most countries, FDI decisions are mostly based on structural business considerations, including whether a country aligns with the overall global trade systems in place. In that context, my view has always been that it’s very difficult for an individual country to do much to change itself, since it is constrained within the geography of its location.”
Elaborating on this, he noted that within the South Asian region, even countries such as India, which had taken considerable steps to improve their investment climate, recorded FDI levels as a percentage of GDP comparable to those of Sri Lanka.
In contrast, he explained that Southeast Asian countries, particularly those in the Association of Southeast Asian Nations (ASEAN), showed significantly higher FDI inflows to varying degrees, despite widely divergent investment climates.
“A better way to understand this is that depending on the confines of your region and how integrated the region is to global trade, change is possible. The issue in South Asia is that we are not particularly well-integrated into global trade, while lacking the advantages that East Asia has in terms of manufacturing labour, or those of Western Europe and the US in terms of consumer markets. We have an in-between bearing and we also lack very strong commodities. At this point, I don’t think that the current situation in itself would change those factors yet,” he said.
Damsinghe further observed that the current situation should be viewed within the broader context of a global economic transition. He explained that over the past few years, the global economy had been undergoing changes across trade, geopolitics, and security fronts.
In a transitioning world, he noted that the traditional economic system where the United States functioned as the major demand centre while different countries – specifically China and East Asia – acted as supply sources over the past two to three decades, may gradually evolve over time.
He added that such shifts were long-term developments, potentially unfolding for over 10–30 years or longer, and therefore the current shock alone was unlikely to result in short-term structural changes.
While portfolio investments in other countries may fluctuate, he highlighted that Sri Lanka remained relatively insulated due to limited foreign participation in its financial markets. For direct investments, he opined that this crisis in itself would not cause significant change. Instead, he highlighted that the way the global economic system itself worked was already undergoing transition, and this was just one more step towards that.
“Is the new world post-economic transition better for Sri Lanka? Perhaps, and perhaps not. However, that is something to be assessed in the much longer term,” he said.
Hidden investment opportunities
Meanwhile, commenting on how the investment sentiment could be leveraged, economist and Centre for a Smart Future Director of Public Policy Anushka Wijesinha noted that FDI and foreign portfolio investment into Sri Lanka would undoubtedly be impacted due to the global uncertainty and an overall risk-off sentiment.
“There could be an opportunity for Sri Lanka on the FDI front, as investors look for options to diversify their supply chains, relook at the geographies they operate in, and take risk mitigation measures.”
However, he highlighted that for this, Sri Lanka needed to substantially enhance its trade and investment attractiveness.
“Centre for a Smart Future published a list of priority reforms last year that included trade facilitation reforms to boost border efficiency, as well as improved commercial diplomacy to advance our export and FDI interests. In the medium-term, it is ultimately our own homework that we can focus on – our own domestic reform agenda must be reprioritised. And not in a traditional way – we have to think innovatively,” he said.
Structural reforms
Furthermore, analysing Sri Lanka’s current economic positioning and structural reforms required for investment, economist Dr. Roshan Perera explained that the Middle East conflict highlighted the country’s vulnerability to external shocks, given its heavy dependence on imported fuel, remittances from the Gulf, and a narrow export base.
She explained that rising oil prices increased the fuel import bill, widened the trade deficit, and added to inflationary pressures, while higher shipping and insurance costs and weaker global demand affected exports.
She also noted that a decline in remittances could further strain foreign exchange inflows, exerting pressure on the exchange rate and foreign reserves.
“Despite these risks, Sri Lanka is better positioned than during the 2022 crisis. Foreign reserves have improved, Government revenue has strengthened, inflation has eased under tighter monetary policy, and the automatic fuel pricing mechanism has reduced the fiscal burden. These buffers have helped contain the immediate impact of the conflict.”
However, she highlighted that structural reforms had lagged. According to her, limited progress in State-owned enterprise reform and energy security, trade diversification, and labour market flexibility continues to constrain investment and growth.
“Sri Lanka’s exposure to external shocks remains high. While short-term stabilisation is important, stronger and sustained economic growth is essential to build resilience and reduce vulnerability to future shocks. This requires investment – especially FDI – which will only come if deeper structural reforms are undertaken,” she said.