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20. There are formidable difficulties to be overcome before any effective changes in this system can be made. A major factor is the very novelty of the concept that the mass of the population should take an active part in any processes of government. This concept, indeed, is not in keeping with the traditional Chinese view of the proper relationship between government and governed and, while times are changing, it is possible that the popular response to the requirements of the new system will be slow: it is even possible that this response will be unfavourable.
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21. One of the arguments put forward against the increase in ferry fares was that it would cause an inflationary spiral". This argument could not be justified by the trivial increase proposed but it was said to be part of a general pattern of rising prices and economic depression; and it gained ground among those who had been affected by the events of the early part of 1965 when two Chinese-owned banks failed and there was a run on others. I referred to this briefly in my last despatch but it was not then possible to assess the situation fully.
22. The lack of confidence in Chinese banks did not cease with the end of the run, and it was not until a controlling interest in the largest (and, in fact, one of the soundest) of these banks had been voluntarily offered to and acquired by the Hongkong and Shanghai Banking Corporation, and certain others had received support from that bank, the Chartered Bank and Government, that a still uneasy calm redescended on the banking world and the process of rebuilding confidence began.
23. In retrospect, it can be seen that the break had come in consequence of an over-rapid expansion of credit and of the unsound lending policies of certain banks, of over-speculation in real estate and of over-speculation in stocks and shares a picture similar to that in many other financial centres during the last year or two.
24. These events constituted a considerable check to progress. Something of a credit squeeze developed, partly because of the relative slump in real estate (many developers being left with unrealisable assets in the shape of completed or half-completed schemes); partly because the financing of small industry and business was disrupted by the loss of deposits experienced by the smaller Chinese banks, their normal source of credit; and partly because banks as a whole became cautious, and eager, not only to restore, but also to increase their liquidity.
25. It seems probable that economic growth, which had in recent years been in the range of 10 per cent to 14 per cent a year, fell to somewhere round 6-7 per cent (which, to the business world, appeared severe depression). These circumstances affected not only the development of trade and industry but also revenue receipts. Both economic activity and revenue began to recover somewhat towards the end of the year. The final out-turn of the public accounts for 1955-66 was a deficit of £84 million, the first deficit since 1960.
26. The 1966-67 Budget forecasts a further deficit of £12 million, in spite of increased taxation (including the first increase in income tax since 1950) designed to produce an additional £5 million. Economic recovery appears, however, to be accelerating again (a spectacular increase in tourist traffic being one of the elements) and it seems likely that while there will be a deficit, it will not be as large as forecast. Even the real estate market is showing some signs of recovery at the cheaper end. Business confidence is returning and the existence of a state of depression is no longer an article of faith in the business world.
27. There has continued to be a substantial inward flow of funds, although partly, but only partly, offset for a time by an outflow to the United States during sterling's difficulties. Bank deposits have continued to grow reasonably fast, although their policy on advances is still cautious. In the year ended 31st August, 1966, deposits rose by 14 per cent but advances by only 3 per cent. The liquidity ratio of the whole banking system is now 48 per cent against 29 per cent prior to the bank run of February last year.
28. Throughout this difficult period there has been constant pressure on Government, and a constant temptation, to use surplus official funds held abroad to buttress the ailing parts of the economy, in particular, the real estate market.
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}