Sri Lanka’s fragile economic recovery is facing its biggest external challenge since the 2022 crisis, with the conflict in the Middle East threatening vital sources of foreign exchange, tourism earnings and remittances, according to IMF Resident Representative Martha Tesfaye Woldemichael.
The IMF official described the conflict as a “major external shock” for Sri Lanka because of the country’s deep economic links with the region. Nearly half of Sri Lanka’s petroleum imports originate from the Middle East, while about 40 percent of remittances flow from Sri Lankan workers employed there. The region also serves as a key aviation hub for tourists travelling to the island.
The impact was immediate. Fuel prices surged, tourist arrivals weakened and inflationary pressures intensified.
However, unlike during the economic collapse four years ago, Sri Lanka now possesses stronger economic buffers. Woldemichael credited reforms undertaken under the IMF-backed Extended Fund Facility (EFF) programme for improving fiscal stability and external sector resilience.
The government has already responded with a temporary relief package covering fuel, electricity, fertiliser and vulnerable households. The package, capped at Rs.100 billion and scheduled to expire in September 2026, has been endorsed by the IMF as a targeted and time-bound intervention.
Recognising the challenges posed by the conflict, the IMF has also adjusted key programme targets. The primary budget surplus target for 2026 has been lowered from 2.3 percent to 1.4 percent of GDP, while reserve accumulation targets have also been relaxed to reflect slower How ever
the IMF warns that flexibility should not be mistaken for a retreat from reforms.“The breathing space exists, but it must be used wisely,” Woldemichael stressed, emphasising that Sri Lanka remains committed to restoring the original fiscal targets from 2027 onward.
The IMF also raised concerns about growing calls for fresh import restrictions amid pressure on foreign reserves. Vehicle imports generated extraordinary tax revenues equivalent to 2.8 percent of GDP in 2025 and helped push the country’s primary surplus to an impressive 5.4 percent of GDP. However, rising vehicle imports have also increased demand for dollars and contributed to pressure on the rupee.
While the government recently increased customs duties on selected vehicles from 30 percent to 45 percent, the IMF cautions against broader import controls.
According to Woldemichael, such measures may provide temporary relief but risk undermining commitments made under the IMF programme. Instead, the Fund advocates allowing the exchange rate to function as a natural shock absorber while pursuing structural reforms.
Despite current headwinds, the IMF remains optimistic about Sri Lanka’s progress. Economic growth rebounded to 5 percent in 2025 after the severe contraction of 2022, while inflation, which once approached 70 percent, fell to 5.5 percent in May 2026. Official reserves climbed to US$6.9 billion, tax revenue reached its highest level in a decade and public debt declined significantly following restructuring efforts.
Still, with one in four Sri Lankans remaining below the poverty line and global uncertainties mounting, the IMF says the next phase of recovery will depend on sustaining reforms that convert stability into lasting growth and jobs.