CONFIDENTIAL
A
special arrangement by which the Hong Kong authorities could
the take in the sterling held by the commercial banks and special feature
redeposit the sterling with the banks in Hong Kong which may then invest those funds as they wish provided only that they continue to hold them in sterling (most countries could only count in their official reserves sterling held directly in London). This was to be achieved by means of the Hong Kong Exchange Fund (which provides the sterling backing for the currency). This arrangement ensured that although the commercial banks' sterling attracted a guarantee, this was under arrangements made between the banks and the Hong Kong Government; the UK guarantees in Hong Kong as elsewhere only sterling held in official reserves.
5. We have now become aware of a danger which was not suffi- ciently appreciated at the time of the sterling negotiations. This is that the sterling holdings of the commercial banks might be swollen by deposits made freely with them by residents of other 0.S.A. countries including the UK. The Hong Kong Government might then take in these increased deposits under the cover of the guarantee thus protecting private non-Hong Kong residents against a further sterling devaluation. Capital can be freely transferred within the sterling area anyway; but if the commercial banks did not enjoy the guarantee they would not want to accept non-resident deposits which gave them an unreserved sterling position. There
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is some evidence of a flow of "hot money" to Hong Kong.
6. Ideally, Exchange Controls could be used either to exclude altogether non-Hong Kong residents' deposits, or to separate these so that they could be kept apart from the funds attracting the UK guarantee. However, the safeguards used at present by the Hong Kong Government to prevent the intake of sterling into the reserves which originates outside Hong Kong are not satisfactory. One difficulty arises from the fact that the Hong Kong Government has offered the protection of the guarantee not only to the three note-issuing banks but to others including the Communist banks (although the present indications are that the latter will not take the offer
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CONFIDENTIAL