The International Monetary Fund on Tuesday warned Sri Lanka that escalating violence in a bitter ethnic conflict could prompt an economic crisis through higher prices and dwindling foreign currency reserves.
The IMF statement followed a round of talks with Sri Lanka over an economic stabilisation programme, which includes loans to prop up the budget and currency.
The island nation imports all of its oil and gas needs and is heavily dependent on textile exports and tourism, both of which have been hit by an upsurge in violence between Tamil rebels and the military since December.
The strain of extra spending as the military battle Tamil separatists has shown-up in the budget deficit, forecast to hit 9.1 per cent of gross domestic product in 2006, compared to 8.7 per cent last year, the IMF said.
"In this context, the rising debt service burden adds to the economy's vulnerability to external shocks," the IMF said in a statement.
The fighting along with rising global oil prices has also spurred inflation to double digit rates, with a forecast of an average 12 percent now for 2006 from 3.6 percent last year, the IMF said.
In October alone prices rose 17.2 per cent compared to the same month last year.
The IMF remarks pushed the Sri Lanka rupee to 108.07 rupees against the dollar Tuesday, almost five per cent weaker since the start of 2006.
The IMF urged the government to adopt policies that would cut inflation and "encouraged" limits on intervention in the foreign currency market to allow greater flexibility in exchange rates.
Fighting between government forces and Tamil Tiger rebels as part of decades of conflict escalated in the past year with an estimated 3,300 people killed despite a truce in place since February 2002.