Sri Lanka’s fragile external position leaves it highly exposed to a sharp rise in energy prices, with the government’s decision to declare Wednesdays a public holiday for state-sector workers highlighting the immediate economic impact of the ongoing issues stemming from the war in Iran.

According to a note from Capital Economics, the country imports all of its crude oil, the vast majority from the Middle East, meaning a sustained period of elevated prices would place renewed strain on the external sector. Oil products account for roughly 20% of total imports, and previous surges in global prices in 2021–22, alongside the spike following Russia’s invasion of Ukraine, were key contributors to Sri Lanka’s sovereign default.

As such, while external conditions have improved, with the current account now in a small surplus, foreign exchange reserves higher albeit still limited, and support from the IMF in place, the economy remains vulnerable. Persistently high oil prices would only increase the import bill and test these buffers. And the currency has already weakened by about 2% against the US dollar since the onset of the conflict, and further depreciation would complicate repayment of foreign-currency debt.

To this end, the move to impose a weekly public holiday for state institutions was intended to curb fuel consumption and ease pressure on the external balance.

Economic growth is also expected to come under strain. Data released since March 16 has shown that momentum had already begun to slow prior to the escalation in the Iran crisis, with GDP expanding by 4.8% year-on-year in the final quarter of last year, down from 5.4% in the preceding quarter. As a result, output remains more than 10% below pre-pandemic levels.

At present, Colombo’s constrained fiscal position limits its ability to cushion households and businesses from higher global energy costs. Domestic fuel prices have risen sharply since the crisis began, eroding real incomes, dampening consumption and weighing on investment. Administrative measures to ration fuel use are likely to further restrict activity, including the introduction of a National Fuel Pass system that caps fuel purchases, alongside the Wednesday public holiday.

Scenario analysis suggests a range of outcomes depending on the trajectory of Middle East tensions. In a more benign case involving a short-lived spike in energy prices, GDP growth, currently forecast at 4.0% for the year, would be trimmed to around 3.8%. In a more severe scenario, where Brent crude averages about $150 per barrel over the next six months, growth could slow to approximately 2.5%.

Attention is now focused on the central bank’s policy meeting on March 19. Inflation stood at 1.6% year-on-year in February, providing some room for policymakers to hold rates steady. However, the deterioration in both inflation and external dynamics reduces the likelihood of rate cuts this year. Under a milder scenario therefore, rates are expected to remain unchanged, while more adverse conditions would likely necessitate monetary tightening.