Sri Lanka’s fragile economic recovery faces a new threat – the potential fallout from an escalating conflict between Israel and Iran and spillovers to the wider Middle East. While geographically distant, Sri Lanka is certainly vulnerable to disruptions in the Middle East, a region crucial for global oil supplies and international trade. Let’s explore the key channels through which an intensified Israel-Iran conflict could cause substantial external headwinds to Sri Lanka – headwinds that the country can ill afford to face right now.
US Treasury Secretary Janet Yellen observed this week that “economic spillovers” from the heightened tensions in the region could hurt global economic prospects. The International Monetary Fund (IMF), on the sidelines of this week’s World Bank-IMF Spring Meetings 2024, observed that there are already jumps in global oil prices, and that their initial estimates suggest prices could increase by 15 percent, but that “it is too early to say if it will be sustained”.
Brent Crude edged closer to US$ 90 per barrel by Friday 19, on the back of a steady 15 percent increase already seen so far since the start of the year. US bank JP Morgan Chase forecast last week that oil would climb to US$ 100/barrel by September this year – and this forecast was prior to the latest Iran-Israel tensions.
Sri Lanka is heavily reliant on imported oil to meet its energy needs. Benign oil prices so far have helped manage the country’s trade balance, amidst a recovery in export earnings, tourism, and remittances over the past 6-8 months. But, any disruption in oil production or exports from the region due to the conflict could send global oil prices soaring.
Global energy analysts at Rapidan Energy Group have warned that Israel-Iran tensions have a “40 percent probability of disrupting shipping and oil trade” at the Strait of Hormuz. The Strait of Hormuz – a narrow 40 km waterway connecting the Persian Gulf to the Indian Ocean (via the Gulf of Oman) is a vital chokepoint for global oil transportation handling over 30 percent of the world’s oil trade. Each day, approximately 20 million barrels of oil and refined products travel through this channel.
Higher oil prices would lead to a ripple effect across the Sri Lankan economy. Transportation costs would escalate, further straining essential services and businesses. At a time when hard won gains in curtailing inflation – thanks to prudent monetary policy measures by the Central Bank of Sri Lanka (CBSL) – this would be a challenging turn of events. The country, already facing a foreign exchange shortage, would struggle to absorb these increased oil import costs.
Trade turbulence and shipping squeeze
The Israel-Hamas conflict had already doubled freight costs to close to US$ 5,000 (per 40 ft container) by end 2023, but had been steadily cooling off in recent months. Some analysts say that with the latest tensions, these costs could double again, to reach closer to US$ 10,000 – rates not seen since the height of the Covid-19 pandemic and associated supply disruptions.
Even without a complete blockade of the Strait of Hormuz, the conflict could lead to a significant increase in shipping costs, and Sri Lanka’s international trade could also disrupted by a wider and protracted conflict. Similarly, the Red Sea, another vital shipping route, could be affected by tensions between Iran and Israel, potentially impacting trade between Europe, Asia, and Africa.
Concerns about piracy and potential blockades could lead to a significant increase in shipping insurance premiums, and shipping companies might be hesitant to operate in high-risk areas. This would make importing and exporting goods significantly more expensive for Sri Lankan businesses. Impacts to Sri Lanka’s exports through this channel would come at a time when the trade balance had been steadily improving and an uptick in exports is just emerging. Delays in receiving raw materials and finished goods could also disrupt key industries.
Indirectly, higher oil prices would also affect demand in Sri Lanka’s key markets. The US, UK and EU have been just coming out of a period of high inflation that affected consumer demand. The recovery in Sri Lanka’s exports to these markets was underway, albeit tentatively. Now, higher oil prices would once again affect spending in these key markets. In response, it is expected by central banks in these markets (like the US Federal Reserve) will factor this in deciding future directions for interest rates – perhaps taking a dovish stance without raising rates further just yet.
Impact on tourism and remittances
Tourism and remittances have seen substantial improvements over the past 6-8 months, and has been a vital contributor in steadying Sri Lanka’s foreign reserves. It is widely acknowledged that long-haul travel is sensitive to fuel prices. Airlines would pass on higher fuel costs through increased ticket prices, making long-haul travel to Sri Lanka more expensive.
Beyond the impact of fuel prices, an escalation in the Middle East conflict could negatively affect Sri Lanka’s tourism industry through travellers from the West hesitating to transit through the region, as most hub airports such as Dubai are located there. Instability in the Middle East could also hurt foreign employment prospects for Sri Lankan migrant workers. An escalating conflict could force them to return or disrupt their employment, leading to a decline in remittance inflows. This would further strain Sri Lanka’s foreign exchange reserves.
Channels that are unlikely to affect Sri Lanka through, at least for now, are capital markets. While episodes like these typically affect global investor confidence and send investors fleeing to ‘safe haven’ assets and away from emerging markets, Sri Lanka will not be impacted by this.
Inflows to Sri Lanka’s capital markets have been meagre anyway, on account of the sovereign default and foreign shareholdings in Government securities are negligible. Unlike other emerging and frontier markets in Asia, Sri Lanka would not be affected by capital flight triggered by an escalating Middle East conflict.
Nevertheless, a protracted and worsening conflict could strengthen the US Dollar as investors seek safe haven assets and bring funds back home. This can put downward pressure on the Rupee, helping Sri Lanka’s exports. Gold prices will also rise for the same reasons, and this would influence the ongoing high growth in gold loans and pawning in the Sri Lanka bank and non-bank financial sector. Gold prices globally – and indeed gold-backed lending domestically – is already at historic highs.
Steady focus
In summary, the escalating tensions in the Middle East pose a significant threat to Sri Lanka’s already fragile recovery. The impact will be felt across various sectors, from rising fuel prices to disruptions in trade and remittances. On the macro front, the Government and CBSL would need to keep a close eye on the fallout of the crisis on Sri Lanka’s foreign reserves – a key indicator that had just begun strengthening. With growing probability of higher global oil prices, Sri Lanka would need to carefully balance the need to continue with the market-linked pricing formula for domestic fuel prices (so as not to reverse hard-won reforms in the energy sector), while ensuring that the impacts to vulnerable household groups are minimised through effective social security.
On the trade front, the Government would need to double down on efforts to boost export resilience, and liaise closely with major export sectors (like apparels, tea, and food products) to identify what policy measures can be taken to support resiliency and facilitate export growth. Meanwhile, from an energy security point of view, the key medium-term strategy of the current Government – to boost energy generation not reliant on imported oil – must continue to remain a priority. Diversifying our energy sources by investing in Renewable Energy like solar and wind would steadily help reduce our reliance on imported oil and shield the economy from future oil price shocks.
