Sri Lanka’s delicate dance with China

Leslie Shaffer-Wednesday, 23 Dec 2015

Sri Lanka is sticking with a close relationship with China even as the island-nation attempts to "reinterpret" its extensive and sometimes poorly managed deals with the mainland, Ravi Karunanayake, Sri Lanka's Finance Minister, told CNBC.

"We have a very close relationship between government to government. It's the government to business (relationship) that the (Mahinda) Rajapakse regime certainly messed up in the sense that it went well beyond what was there," Karunanayake said in an exclusive interview.

In August, the United National Party defeated former president Rajapakse's United People's Freedom Alliance (UPFA) party in parliamentary elections, meaning Rajapakse would not be forming the new government. In January, the current president, Mithripala Sirisensa, also of the UPFA party, ousted his one-time mentor Rajapaksa.

During Rajapakse's decade-long tenure, he encouraged Chinese infrastructure investment in the country, with many of those deals and contracts now coming under scrutiny and potential cancellation amid allegations of corruption.

"We have a friendly persuasion (with China). All we want to do is correct the ingovernance (sic). That's what China is doing. That's what Maithripala Sirisena government is doing," Karunanayake said. "It's a reinterpretation of how clean government should be."

Earlier this month, the government said Chinese deals worth billions of dollars would proceed after nearly a year of delays as the contracts remain binding even though there was no competitive bidding and some projects weren't well conceived, Reuters reported.

But the new administration has broken with its predecessor's China-focused tendency and is now pursuing business with other countries as well.

"Certainly, China is a great player. India is as big. You have European Union, U.S., Japan, Korea, all were left out. But all of them can come in," Karunanayake said. "What we want to do is the Sri Lanka economy which was made to look small will be made open. And integrate with the world."

The "reinterpretation" of those contracts may be essential to government finances -- Reuters reported that Sri Lanka owes more than $5 billion to Chinese lenders.

Overall, Sri Lanka's new government has inherited more than $25 billion in debt to offshore creditors, or around a third of gross domestic product (GDP), noted Mark Mobius, executive chairman at Templeton Emerging Markets, in a blog post earlier this month.

"Interest payments are estimated to consume about 40 percent of government revenue, a real problem when the Sri Lankan rupee has devaluated in recent years by as much as 20 percent," he said.

The International Monetary Fund (IMF) also has some concerns about government finances.

"Deterioration in the overall balance of payments, the loss of central bank foreign exchange reserves, the weak state of public finances, and growing public debt are reasons for concern," the IMF said in a note earlier this month, although it added that the current account deficit may narrow due to lower oil prices.

The IMF advised comprehensive reforms, including fiscal consolidation to put the government's finances on a more sustainable footing.

Sri Lanka's government appears to be taking note.

Karunanayake said the government is aiming for a budget deficit of 5.8-5.9 percent of GDP in 2016, after inheriting 7.1-7.2 percent budget deficit.

"For the first time, we are fixing our recurrent expenditure," he said. "This has never happened for the past 15 years. So you could see that financial discipline coming in."

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1