Shock from the Gulf: Buffers hold for now but reform delays leave SL vulnerable

Israeli soldiers walk by a billboard commissioned by the evangelical Christian group Friends of Zion during the US-Israel war on Iran in Tel Aviv, Israel 

Conflicts in the Middle East rarely remain confined to the region. The area is at the centre of the global energy system and key maritime routes. Hence, any conflict in the region impacts the rest of the world. For small, open economies such as Sri Lanka, the risks are particularly high.

Around 20% of global oil supply and nearly one-third of liquefied natural gas (LNG) trade passes through the Strait of Hormuz, making it one of the world’s most strategic energy regions. When tensions escalate in the region, energy markets react quickly. Higher oil prices, increased shipping costs and financial market volatility typically follow, placing pressure on energy-importing countries.

Sri Lanka is especially vulnerable because of its heavy dependence on imported fuel, its reliance on remittances from the Gulf, and its concentration of export markets.

Why the Middle East conflict matters for Sri Lanka

Sri Lanka imports nearly 100% of its petroleum requirements. Annual fuel imports amount to roughly $ 4 billion. A $ 10% increase in global oil prices could increase the country’s fuel import bill by about $ 400–500 million annually. This has several knock-on effects.

First, it worsens the trade balance. Sri Lanka’s trade deficit in 2025 was almost $8 billion, and higher fuel costs immediately widened that gap. Second, higher oil prices translate into inflation. Transport costs rise, electricity tariffs increase, and production costs across the economy escalate. Around 35% of the global supply of fertiliser comes from the Middle East. Any disruptions to supply will affect global food supply, pushing up food prices. Third, export sectors face new pressures. Freight and insurance costs increase as shipping routes become riskier. At the same time, global economic uncertainty may weaken demand for Sri Lankan exports such as apparel, tea and rubber products.

Sri Lanka’s exposure to the Middle East is also visible in its remittance flows. In 2025, the country received about $8.1 billion in remittances, with a large share originating from Gulf countries such as Saudi Arabia, the UAE, Qatar and Kuwait. If conflict disrupts labour markets or forces migrant workers to return home, remittance inflows could decline sharply. Even a 10% drop could reduce foreign exchange inflows by several hundred million dollars annually. Taken together, higher fuel import bills, weaker remittances and export disruptions could place pressure on the exchange rate, foreign reserves and fiscal balances.

Why Sri Lanka has yet to feel the worst effects

Despite these vulnerabilities, Sri Lanka is better positioned today than it was a few years ago. The economic crisis of 2022 forced the country to undertake painful but necessary macroeconomic reforms. Since then, several policy buffers have been rebuilt.

Foreign reserves have been gradually restored through the Central Bank’s purchases of foreign exchange. While still below comfortable levels, reserves are far stronger than during the crisis years. Tax reforms have also strengthened Government revenue, allowing the creation of rupee cash buffers. These buffers enabled the Government to finance relief and rehabilitation after Cyclone Ditwah without resorting to emergency borrowing. Similarly, the shift to inflation targeting and tighter monetary policy helped bring inflation down significantly, providing some space for price adjustments before interest rates may need to rise again.

One of the most important reforms was the introduction of an automatic fuel pricing mechanism. Unlike in the past, fuel prices can now adjust more quickly to global price movements, preventing large losses in the energy sector and reducing pressure on the fiscal sector.

Because of these reforms, the macroeconomic impact of the Middle East conflict has so far been relatively contained. However, these buffers are not unlimited. If the conflict drags on and global energy prices remain high, Sri Lanka’s resilience will depend on deeper structural reforms that have been slower to materialise.

The Middle East conflict is a reminder of how vulnerable Sri Lanka remains to external events beyond its control. But the deeper lesson is that resilience must be built before crises occur. Macroeconomic stabilisation after the 2022 crisis has given Sri Lanka some protection against global volatility. Yet without structural reforms that diversify exports and improve competitiveness, the country will remain exposed to future shocks. Sri Lanka cannot control its exposure to shocks such as the recent events in the Middle East. What it can control is how prepared its economy is when those shocks arrive

The reforms Sri Lanka delayed

While macroeconomic stabilisation has progressed, structural reforms have lagged. This is a critical weakness. Sri Lanka’s low growth environment means the country has not generated the economic resources needed to withstand external shocks. Several reforms that could have strengthened resilience remain incomplete.

State-owned enterprise reforms are one example. Opening sectors such as fuel, LNG and ports to greater competition and private investment could have increased efficiency and capacity. Limited storage facilities for petroleum and LNG also leave the country exposed to supply disruptions and price volatility.

Trade reforms are another missing piece. Sri Lanka remains highly dependent on a narrow set of export products and markets. Nearly half of its tea exports go to the Middle East, making the sector directly vulnerable to regional instability. Apparel exports are also exposed to rising freight costs and disruptions in global shipping routes. Reducing para-tariffs and non-tariff barriers could attract foreign investment into new export sectors and help diversify the economy.

Finally, labour market reforms have lagged. Sri Lanka’s labour laws remain rigid and often discourage job creation. Instead of expanding domestic employment opportunities, many workers migrate to countries with more flexible labour markets. Without reforms that improve productivity, encourage investment and expand export capacity, Sri Lanka will continue to struggle to build the economic buffers needed to withstand global shocks.

What needs to be done

Responding effectively to the current crisis requires a combination of short-term stabilisation measures and long-term structural reforms.

nShort-term priorities

In the immediate term, policymakers must focus on managing external shocks. Strategic fuel management is critical. Maintaining cost-reflective fuel pricing, managing demand and ensuring adequate fuel inventories can prevent sudden shortages. Exchange rate flexibility should also be maintained. Allowing the rupee to adjust gradually can absorb external pressures while protecting foreign reserves. Finally, safeguarding remittance flows is essential. Supporting migrant workers and strengthening formal remittance channels can help maintain foreign exchange inflows.

nMedium-term reforms

Over the next few years, Sri Lanka needs to reduce structural vulnerabilities. Energy diversification should be a priority. Expanding renewable energy, developing LNG infrastructure and improving energy efficiency can reduce reliance on imported oil. Establishing strategic petroleum reserves would also help cushion short-term supply disruptions. Many countries maintain such reserves to protect themselves from geopolitical shocks. Trade diversification is equally important. Expanding market access in regions such as ASEAN, Africa and East Asia can reduce dependence on a few traditional markets. Labour migration strategies should also diversify beyond the Gulf region.

nLong-term transformation

Ultimately, the most important policy response is stronger economic growth. Sri Lanka may have missed opportunities in large-scale manufacturing, but it can still build capabilities in high-value services such as IT, logistics, finance and professional services. Achieving this will require significant investment in education, skills development and labour market reform. In addition, continued fiscal discipline and the rebuilding of foreign reserves—ideally covering four to six months of imports—are essential to protect the economy from future shocks.

 The lesson from this crisis

The Middle East conflict is a reminder of how vulnerable Sri Lanka remains to external events beyond its control. But the deeper lesson is that resilience must be built before crises occur. Macroeconomic stabilisation after the 2022 crisis has given Sri Lanka some protection against global volatility. Yet without structural reforms that diversify exports and improve competitiveness, the country will remain exposed to future shocks. Sri Lanka cannot control its exposure to shocks such as the recent events in the Middle East. What it can control is how prepared its economy is when those shocks arrive.

(The author is Economist and Team Lead Centre for Poverty Analysis)