SECRET
HONG KONG GOVERNMENT PAPER
1. For historical reasons, the banks in Hong Kong are in a difficult position in that a sizeable part of their assets is held in foreign exchange, predominantly in sterling, whilst the bulk of their liabilities is expressed in Hong Kong dollars. In normal circumstances with such abnormally large holdings they would be subject to an exchange risk in the event of a change in the international value of sterling. This exchange risk is covered at present by the Hong Kong Government under arrangements entered into with the banks. The Hong Kong Government is able to cover the risk in part from external sources, by reason of the guarantee provided by the Sterling Agreement.
2. For so long as the Hong Kong banks have no option but to hold a sizeable proportion of their assets in foreign exchange, the Hong Kong Government is likely to be under heavy pressure to offer foreign exchange guarantees to the banks. In large measure, this is legitimate pressure; for in the absence of guarantees linked to the Hong Kong dollar the banks, because of their abnormally large holdings of foreign exchange, are forced to take risks which are not normally faced by commercial banks. The banks have, for example, made clear the distaste with which they regard the possibility of large uncovered sterling positions after September 1973. But in the future, exchange rates may well move more frequently than in the past, so that risks will attach to any foreign exchange holdings. A continuing guarantee (or maybe set of guarantees covering currencies other than sterling) by the Hong Kong Government to the banks could be complex, and such guarantees might well be more costly to the Hong Kong Government than if their reserves were under their direct control. For non- sterling currencies, the Hong Kong Government cannot look for cover for any guarantees it may feel it necessary to give to the banks; and without in any way prejudging the terms of any successor Sterling Agreements after September 1973, it cannot be assumed that HMG's guarantee will continue indefinitely. Indeed we look forward to developments in the international monetary