Iran war casts fresh shadow over Sri Lanka’s recovery

• Fitch turns more cautious on emerging markets

Sri Lanka’s fragile economic recovery faces renewed external headwinds after Fitch Ratings downgraded its outlook on a growing number of emerging market sectors, warning that the ongoing Iran conflict is weakening growth prospects, fuelling inflation and increasing financial risks across developing economies.

Sri Lanka has already been forced to absorb the fallout from the Middle East crisis through higher fuel costs, rising inflation, currency pressures and tighter monetary policy.

Fitch this month shifted more emerging market sector outlooks to “deteriorating”, reflecting the broader impact of the conflict on economic activity and financial stability. For the island nation, the risks are far from theoretical.

The Central Bank of Sri Lanka (CBSL) in May delivered a surprise 100-basis-point increase in its Overnight Policy Rate to 8.75 percent, the largest rate hike in more than three years. It cited inflationary pressures and currency weakness linked to the global oil shock triggered by the conflict. Inflation accelerated to 5.4 percent in April while the rupee came under pressure amid rising import costs. 

The latest Fitch assessment suggests those pressures may not ease quickly.

In a separate global outlook, Fitch said the oil crisis prompted by the Iran war had already led it to lower its 2026 global growth forecast to 2.4 percent as higher energy prices squeeze consumer spending and raise business costs. 

The CBSL previously warned that geopolitical tensions could significantly alter the global inflation trajectory. In its latest macroeconomic assessment, the CBSL noted that while the IMF had projected average oil prices of around US$ 62 a barrel this year, recent developments had pushed Brent crude above US$ 100 at times, creating risks of higher inflation, shipping costs and imported price pressures. 

Higher oil prices threaten to increase Sri Lanka’s import bill, pressure foreign reserves and complicate efforts to stabilise the external sector, even as tourism earnings, remittances and exports continue to recover under the IMF-supported reform programme. Analysts have already warned that prolonged monetary tightening could slow credit growth and investment, potentially tempering the recovery momentum that emerged over the past year. 

Central banks across emerging and developed markets are reassessing policy settings in response to energy-driven inflation. Policymakers from Europe to Asia have signalled that inflation risks remain elevated despite tentative signs of easing geopolitical tensions.