CONFIDENTIAL
Mr Holland
Mink
24/7
HONG KONG EXCHANGE FUND
1.
We have now received the attached report and accounts of the Exchange Fund from the Finance Branch, Hong Kong. While I was in Hong Kong last week Mr Haddon-Cave spoke to me about the report, the implications of which he said were "about the most closely guarded secret in Hong Kong". The reason for his concern is summarised in para. 12 of the report which makes it clear that the assets of the Fund now constitute cover of only 81.4% for bank notes issued. This compared with cover of 117% in 1972 and 138% in 1971. Mr Haddon-Cave said that this failure to maintain 100% cover was not illegal. Apparently Hong Kong law provides only that where cover exceeds 105%, the balance may be transferred to the fiscal reserves. But Mr Haddon-Cave said that if it became known that the cover for Hong Kong's currency was less than 100%, this could have a disastrous effect on public confidence.
2.
The reasons which he gave for the reduction in cover were the decline in gilt-edged values and the payments which had had to be made out of the Exchange Fund to clear the undertaking to Hong Kong banks under the Exchange Fund guarantee scheme.
As we already knew, these payments out of the Fund greatly exceeded (because of the denomination of the guarantee in Hong Kong dollars) the payments made into the Fund under the UK sterling guarantees.
3.
Mr Haddon-Cave said that the position would right itself over the next four or five years as a result of interest accruals and the maturity of some of the gilt-edged investments. But meanwhile he thought there would be a period of acute anxiety. It was not possible to top up the Exchange Fund by a transfer from fiscal reserves, because this would draw attention to the fact that the Exchange Fund had been at less than 100% cover and would itself affect confidence. But he was forced to earmark an appropriate sum in the fiscal reserves against the shortfall in the Exchange Fund, and this was a major reason why Hong Kong's main reserves could not be used to finance development in a situation of budget deficit.
4.
The Hong Kong Secretary for Economic Affairs, Mr Jones, separately expressed some doubt to me about the validity of Mr Haddon-Cave's fears. He pointed out that many countries have less than 100% cover for their note issue. When I expressed this doubt to the Governor he agreed that Mr Haddon-Cave might be wrong. But where confidence was involved, irrational factors entered in and he could not afford to treat Mr Haddon-Cave's advice light-heartedly, since he was in the last resort responsible for Hong Kong's stability.
5.
I have minuted separately on the feeling of economic malaise which I encountered in Hong Kong. The current deficit in the Exchange Fund has contributed substantially to this feeling. The Governor has to rely on his financial advisers (which means mostly Mr Haddon-Cave) for an analysis of the implications. Mr Haddon-Cave is determinedly pessimistic. But he does not believe in the Governor's development programmes, and his advice must be to some extent suspect.
CONFIDENTIAL
16.