CODE 18-77
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Reference...
13. Panic would hold two difficulties for the financial system in the Territory. First, attempts to convert HK$ deposits into foreign exchange either directly, or through withdrawing banknotes if banks offer a more attractive rate because of their ability to change these HK$ notes at 7.80 - could easily overwhelm the current attempts to hold the exchange rate. Either convertibility of HK$ deposits into notes would have to be abandoned, or those parts of the system whose US$ reserves are being run down (at present apparently the note- issuing banks, but the Exchange Fund if these banks attempt to rebuild reserves by cancelling HK$ notes against the US$ that would be provided against Certificates of Indebtedness) would reach the point where the 7.80 commitment could not be honoured.
14. Second, attempts to transfer foreign currency deposits abroad would place HK financial institutions under severe liquidity strain. Banks abroad only accept a deposit liability transferred from an institution in the Territory if that institution also transfers an acceptable corresponding asset - probably foreign currency. If the HK bank has to go to the interbank market to borrow foreign currency and restore its liquidity position, or offer more attractive terms to prevent holders of foreign currency deposits from attempting to transfer them abroad, interest rates on foreign currency assets rise, reducing the relative attractiveness of HK$ deposits and putting further pressure on the currency. If attempts to shift foreign currency deposits abroad persist, the HK financial system would not be able to provide corresponding assets (since their liquid assets are a fraction of their deposit liabilities), and foreign banks would not accept claims on HK banks. Convertibility the basis of financial confidence - would have broken down.
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15. The Territory is clearly in no immediate danger of reaching such a position. It is important that the HKG is prepared to counter a slide towards the worst case. This will require more than tinkering with a note-issue arbitrage mechanism that they do not seem to have had the confidence to let operate (possibly with good reason).
Nick Hallett.
N O Hallett
Economic Advisers WH425B
233 5335
16 July 1984
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