Middle East conflict threatens Sri Lanka recovery as inflation, tourism and reserves come under pressure

Sri Lanka’s economic recovery is facing renewed pressure as the escalating Middle East conflict begins to feed through to inflation, tourism, and external balances, the Asian Development Bank (ADB) said.

The island entered 2026 from a position of relative strength, recording 5.0 percent growth in 2025, supported by broad-based expansion across services, industry, and agriculture. However, the outlook is now clouded by rising geopolitical risks and global supply disruptions.

Growth is expected to moderate to around 4.0 percent in 2026, while inflation, which had remained subdued through much of 2025, is projected to rise to about 5.2 percent as energy costs feed into the economy.

Early signs of stress are already visible. Inflation accelerated in March 2026, driven by higher fuel and transport costs, while tourist arrivals declined sharply as disruptions to Gulf airspace affected a key travel corridor to Sri Lanka.

At the same time, official reserves fell to around 7.0 billion dollars in March, indicating the initial impact of external pressures linked to higher import costs and market volatility.

The ADB identified energy markets as the central transmission channel of risk. The near halt of shipping through the Strait of Hormuz has disrupted global supply chains, while oil prices have risen sharply. For Sri Lanka, a net importer of fuel, this directly increases the import bill and adds pressure on inflation and the balance of payments.

Beyond energy, the conflict poses risks to multiple external inflows. Remittances and tourism earnings could weaken if the situation persists, while global trade uncertainty and tariff developments may weigh on export demand.

The report cautioned that risks to the outlook are heavily tilted to the downside. In a prolonged conflict scenario, Sri Lanka could face an additional increase in inflation of up to 3 to 5 percentage points, alongside a reduction in growth over 2026 and 2027.

Financial markets have already begun to reflect heightened uncertainty, with equity indices reversing gains as investors shift towards safer assets.

Policy responses will be critical in managing the impact. The ADB advised against broad-based energy subsidies, instead recommending targeted fiscal measures to protect vulnerable groups while preserving macroeconomic stability. It also highlighted the need to accelerate renewable energy adoption to reduce dependence on imported fuel.

In addition, strengthening public investment management remains a priority. Capital spending has consistently fallen short of budgeted levels, limiting the effectiveness of growth-oriented expenditure. Improving project planning, execution capacity, and accountability could help unlock stronger medium-term growth.

Sri Lanka’s recovery, the ADB said, is now entering a more complex phase, where external shocks will play a larger role. The ability to maintain reform momentum while managing global volatility will be key to sustaining stability and growth.