SECRET
6.
the
There are a number of circumstances favourable to the scheme in Hong Kong. The HK banking system at present has a substantial net foreign currency position, so it should in principle be prepared to make some switch into HK Ss (there is a particularly strong position at Hongkong and Shanghai Bank). The presence of a number of major foreign banks would also be a potential source of strength if they were prepared to switch into HK $s, as they might have to if they wished to continue in business in Hong Kong. It is also a source of strength that many HK businesses are thought to have built up large US holdings (through leads and lags on trade payments) over recent months, and that the Colony is to a large extent already on a dual currency basis. Rather than borrow at very high HK % interest rates they might prefer to draw on their US 8 holdings, or borrow at lower rates in US s against them, or against expected future earnings, thereby reducing the pressure on HK interest
rates.
Arguments for and against
7. It is hard to predict what effect the scheme would have in practice, but there are certainly serious risks. There could easily be teething problems, with the possibilities of runs on local Chinese banks, or huge demand for US $ notes both of which the authorities would need to be ready to meet. At best the scheme would help restore confidence generally, maybe even reducing interest rates. With the exchange rate seen to have been stabilised there would be little if any upward pressure on interest rates. At worst there would be a rush to try to get out of the HK while the rate was thought to be "pegged". The way the scheme works this would put the main strain first on banks; and then on interest rates - which could rise very sharply indeed. The effect of this could (some said would) be to precipitate further collapses in the already weakened property sector. It would also be uncomfortable for the many individuals who have financed house purchase with floating rate loans. In the end however, if everyone became convinced the peg would last there should in principle be no difference between US £ and HK % interest rates - though rates on both currencies might be higher in Hong Kong than elsewhere to reflect the political risk.