Mr Stuart
CONFIDENTIAL
HONG KONG EXCHANGE FUND
Discussed with Dr Holland
Pla des
Yuld Arcent of lax.
2.
The straightforward answer to the request in your minute of 16 July for comments on the Exchange Fund Report and Accounts is that I have none. This is a factual and routine document, and I am sure that the facts recorded are accurate.
2. But I recognise that your request goes deeper than that; essentially, I imagine, you are asking whether à mechanism like the Exchange Fund is an appropriate mechanism for Hong Kong in this day and age. The Bank of England is, of course, the real source of advice on monetary machinery: and "private advice on which the Governor could rely" could better come from them. You might, indeed, like to consider when and how the Bank of England could be brought into this exercise.
3. So far as I am aware, those at the Bank who are best versed in Hong Kong financial matters still take the view that it would be in the interests of Hong Kong to move towards a situation in which the centre-piece of the financial machinery in Hong Kong should be some form of Monetary Authority. This, of course, is more easily said than done. Any transition towards new machinery has to be handled with extreme care because of potential problems of confidence in general and of confidence in the banking system in particular. No doubt these sorts of problems are more acute in Hong Kong than elsewhere; but I would be surprised if they were insuperable given the whole-hearted support of the Government of Hong Kong. Without that, of course nothing can be done: it would indeed be dangerous even to contemplate that a "solution" could be imposed without the active support of the Government of Hong Kong.
4. That said, I am pretty sure that what is really at issue here is not just a question of machinery. At bottom is, I suspect, the problem of financial control. Anyone who serves as a Chancellor of the Exchequer or equivalent cannot fail to be acutely conscious of pressures to spend more and to give the public sector a larger role. Almost inevitably, it is he who has the thankless task of convincing his colleagues (and perhaps sections of the general public) that this or that otherwise worthy scheme cannot be afforded. There is indeed a sufficiency of examples to demonstrate that profligacy leads to ruin of one sort or another. In these circumstances, it is very useful for Chancellors and their like to be able to pray in aid certain rules or nostrums to support their case. This is where something like the Exchange Fund, antediluvian though it may be, can come in handy. Those reserves are just not available for spending, because they are earmarked as cover for the currency. If, as at present, the exchange fund
/reserves
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reserves do not provide 100% cover, then it is "prudent" to earmark other reserves as well, so that they are not available for spending either. As it is not a legal requirement to hold 100% cover, the argument may need to be bolstered by references to the effect on "confidence" should less than 100% cover be maintained.
5.
You will recall that essentially the same sort of point surfaced when some time back the suggestion was put to Hong Kong that a start might be made on the issue of Government paper. After some rounds of shadow-boxing, it emerged that if internal borrowing became part of the Hong Kong scene it would be more difficult to resist the pressures to finance all manner of expenditure in this "easy" way.
6.
Two questions arise, neither of which can easily be answered. The first is whether the "system" (which, of course, embraces much more than the exchange fund itself) is associated with a misallocation of resources. Of course there are benefits from holding foreign exchange reserves: but if foreign exchange reserves are greater than are needed (the definition of need is of course very difficult) at a time when there is a need (again, a difficult definition) for internal expenditure for the benefit of the economy, then there is at least a potential misallocation of resources. At all events, it can only be a very crude solution to a difficult problem to say, e.g. that it is right that nearly every note in circulation should be covered by foreign exchange holdings.
7. The second is whether the system as operated in Hong Kong can have the flexibility of action and response which may be required these days. In my earlier paper on Hong Kong's monetary system I set down some of my worries on this score: so I will not repeat them here.
8. I can well understand the frustration which the Governor must feel when he is told that his development programmes cannot be afforded. Everyone who espouses programmes of spending has this experience from time to time. It may well be- indeed I suspect it is - that the Hong Kong financial system as now operated has a very conservative bias. But obviously we cannot say from here "it will be safe for you to press forward with your programmes because your Financial Secretary is exaggerating the risks".. I am afraid that there is no short-cut substitute for detailed analysis which goes far beyond the question of whether money is available. Thus if, for example, the Governor's programmes involve additional work for the construction sector it becomes important to know whether that sector has the capacity to handle that work: clearly the real costs to Hong Kong will be different if there is surplus capacity than they will be if that capacity has to be bid away from other work.
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9. This is no more than to say that nothing can or should be done to the financial system which will give carte blanche to any development programme, no matter how well-intentioned it may be. There must be a balance of some sort between those who see a need to spend more and those who see a need to spend less. You don't eliminate the inherent tension by changing the system, or even by changing the Financial Secretary.
10. What is in principle possible is that there should be a full understanding of what the costs, benefits, and risks may be; so that a judgement can be made (and it must in the end be a political judgement) on where the best interests of Hong Kong lie. It seems clear that this process does not work at all well in Hong Kong. Indeed if you have on the one side someone who professes that he does not understand these things (and, frankly, does not seem disposed to try) and on the other some- one with a very full measure of confidence in his opinions and judgements (who, again frankly, seems little disposed to recognise that there may be more than one view), you have a recipe for the sort of vague but deep suspicion which both sides now confess to.
11. I am afraid that all I can suggest in present circumstances is that the Governor should continue to plug away and make a genuine attempt to reach a fully-informed view. As he thinks that his programmes are very important for Hong Kong, he must require to be convinced that they cannot be implemented. If he is faced with some piece of doctrine which he does not understand, e.g. that it is essential for confidence that a very high proportion of the note issue is covered by holdings of foreign exchange, he should question it. If he is told that that is the way the Exchange Fund operates, why does it have to operate in that way? What do other countries do; and what are the pros and cons of doing things in
And so on, and on. That this is an uphill task
And I fear that it is also true that there is
a different way?
cannot be denied.
a substantial body of opinion in Hong Kong who can sniff dangerous radicalism even in the Financial Secretary.
24 July 1974
c.c.
Sir D Watson
Mr Male
Mr Crowson
CONFIDENTIAL
D
D G Holland