As tensions in the Middle East escalate, the world watches anxiously. But for Sri Lanka, this is not merely a diplomatic concern; it is a looming economic threat with the power to derail what has thus far been a fragile recovery. The Israel-Iran conflict, which may soon draw in the United States directly, has reached a tipping point and while the rest of the world is scrambling to cushion its impact, the Government of Sri Lanka appears to be preoccupied with domestic politicking.
The National People’s Power (NPP) regime, which appears to be struggling to come to terms with economic reality, must realise that the Israel-Iran conflict has the potential to cause economic havoc and therefore must act with urgency and foresight to mitigate the risks of fuel price shocks, remittance losses, and reserve vulnerabilities, leading to external debt complications.
In two weeks’ time, Donald Trump is to announce whether the US will directly get involved in the Israel-Iran conflict and at about the same time, the temporary suspension of US trade tariffs will also come to an end, meaning reimposition of the punitive 44% tax on Sri Lankan exports to the US. Therefore, the next two weeks will be critically important for Sri Lanka’s economy for the simple reason that although the wars and conflicts may be distant, their implications for the nation are very much local.
For all intents and purposes, despite a pat on the back by the International Monetary Fund (IMF) in its latest review, Sri Lanka’s economic recovery is still very much a work in progress. The scaffolding holding up the economy today – IMF support, debt restructuring, and modest growth – is highly sensitive to external shocks. A major war in the Middle East, combined with US tariff pressure and disrupted trade, could trigger a cascade of setbacks that the nation is unprepared for.
If war in the Gulf region intensifies, particularly with American military involvement, oil prices will likely surge. The Strait of Hormuz, through which 20% of the world’s oil passes, could become a flashpoint. Even though Sri Lanka imports oil from Singapore and India, supplies for these nations originate from the affected region; therefore Sri Lanka is not immune from the cascading effect.
A potential 10% surge in global fuel prices could in turn impose an additional $ 400 million burden on Sri Lanka’s fuel import bill – a burden the nation is ill equipped to bear short of significantly raising prices at the pump. Its impact on transport, electricity, manufacturing, and food prices could easily lead to unwanted and unnecessary outcomes reminiscent of the not-too-distant past.
The collateral damage from trade and export disruption could be considerable. Most of Sri Lanka’s cargo from Europe and North America transits the Middle East. Conflict in this region would likely push up freight and insurance costs, delay shipments, and disrupt supply chains – all of which could potentially choke the export economy.
Ceylon Tea exports to Iran and Israel – both key markets, are already compromised. An escalation will likely bring tighter sanctions on Iran and uncertainty over Israeli trade channels. The loss of these markets would lead to unsold stock and thus, lower prices. Making matters worse, the grace period on new US trade tariffs expires on 9 July. If no agreement is reached – and none appears imminent – Sri Lanka will have to brace for a 44% tariff on exports to the US from 10 July. Combined with war-related freight inflation, such a tariff would severely weaken Sri Lanka’s competitiveness.
Besides, a prolonged conflict could lead to other implications as well. Approximately 20,000 Sri Lankans work in Israel, most in construction and caregiving. Their remittances form a crucial part of foreign exchange inflows. But the impact is broader. Roughly 42% of Sri Lanka’s total worker remittances come from the Middle East. Any sustained conflict or labour disruption in the region could severely undermine this key pillar of foreign exchange revenue. In a worst-case scenario, where Sri Lanka is compelled to deal with the consequences of a growing conflict, it must urgently put in place the safeguards it failed to employ back in 2022. The last thing the country needs is another foreign exchange crisis. While Sri Lanka remains acutely vulnerable to external shocks, the Government needs to be agile enough to mitigate these shocks; after all, as the saying goes, once bitten, twice shy.
Sri Lanka’s public debt-to-GDP ratio ballooned to 126% in 2022, largely due to excessive borrowing, sweeping tax cuts, and currency depreciation. The IMF’s Sovereign Risk and Debt Sustainability Analysis (SRDSA) makes it clear that Sri Lanka is not expected to bring its debt ratio below 95% until 2032 – assuming the IMF programme is completed in 2027 and all restructuring commitments are fulfilled.
The grace period on debt repayments ends in 2027, after which debt servicing will spike from 2028 through 2038, when restructured international sovereign bonds must be repaid. During that period, debt service burdens will weigh heavily on public finances, potentially at the expense of investments in infrastructure, education, and healthcare. As of January, Sri Lanka’s foreign debt stood at $ 36.7 billion, or 36.46% of total public debt. With gross official reserves stagnant at around $ 6.2 billion for the past six months or so, any shock to the balance of payments – from higher energy costs to reduced remittances – would increase debt distress and undermine confidence in debt servicing.
Moreover, any pressure on the balance of payments could accelerate currency outflows, resulting in exchange rate depreciation. This not only increases the rupee cost of imports but also raises the local currency value of foreign debt, further complicating Sri Lanka’s debt servicing obligations. Sri Lanka’s goal of achieving 5% GDP growth in 2025 is essential to remaining on track with IMF commitments, even though the latest forecast for 2025 remains under 4%. Without that growth, the maths stops working – budget deficits widen, debt ratios stall, and confidence in reform collapses. It is for this reason that every external threat, be it from oil prices to trade barriers to lost remittances, must be treated as a domestic emergency.
The onus on keeping the economy afloat during these testing times falls squarely on the shoulders of Sri Lanka’s new Treasury Secretary, who takes office at a time of extreme uncertainty. He is not stepping into a conventional role. He is being thrown into the deep end, in what is nothing short of a sink-or-swim moment for him, the economy, and the country. Therefore, his first order of business should be to assess how these new external shocks affect debt repayments, tariff deadlines, foreign reserve risks, and IMF performance criteria. As for the regime, this will require not just financial management, but strategic thinking, diplomatic agility, and above all, political courage to be upfront with the people.
The Government must act to fast-track trade deals with ASEAN and South Asia in order to counter potential losses from Iran, Israel, and the US. It should also look at new foreign employment channels to offset potential losses in the Middle East. In the interim the regime must be cautious in busting reserves unnecessarily and avoid politically tempting but fiscally damaging policies.
Long before 2022, the signs were clear, yet that regime lived in denial until it was too late and bankruptcy was the outcome. Today, amidst new global developments, the signs are clear. The window for decisive action is narrow. The Israel-Iran conflict could quickly escalate into a regional or global crisis, with Sri Lanka caught in the economic crossfire. The cost of complacency will be counted in lost growth, increased debt, and shattered hopes of economic recovery.
Sri Lanka has come a long and painful distance since 2022 and sliding back into those dark times is not an option, even though it may be due to reasons beyond the Government’s control. That is why it is important for the Government to act now, and not react when it’s too late.