We think Sri Lanka’s fundamental macroeconomic transition towards a more structurally different economic regime faces its sharpest test yet with the Iran War, but we remain confident the fundamental trajectory holds through 2026 and beyond, compared to the up-down cycles of the past. However, we think there will still be adjustment costs alongside a volatile period where there could be swing movements in prices, broad interest rates and exchange rates going forward, before reverting back.
Part of this is also due to the current war, which we see two broad pathways where the could unfold. In one avenue, a prolonged limbo that gradually deescalates is possible, where escalations exist but at much lower intensity than in the last few months. In the other, a sharper but shorter escalation precedes a new normal settling in. We think both scenarios still carry significant costs, with the broader impact differing across the two pathways but creating volatilities nevertheless.
Given that May was largely an eventful month with the currency spiking to 350, a 100 bps CBSL rate hike, and market rates rising nearly 150 bps we believe all of this looks like an overshoot driven by sentiment, while the fundamental story, we feel, still holds enough firepower to correct these spike movements. Given the economic performance of the Sri Lankan economy over the few months and years fundamental strength remains the centerpiece of our view.
Factoring all of this we hold the current view that the present context reflects an accumulation of negative shocks, which we view as interruptions rather than structural reversals from Sri Lanka’s economic trajectory. That said, we do not rule out the possibility that risks remain, with significant knock-on effects worth watching — including further Iran War escalation with rapid intensity, Middle East supply destruction, and weather-related and geopolitical shocks that could leave a meaningful dent on the new fundamental trajectory.