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FINANCIAL STRUCTURE
The value of currency issued by the note-issuing banks is regulated by an Exchange Fund, which was set up in 1935 when the Hong Kong dollar ceased to be based on silver. Briefly, the fund receives payment from these banks in exchange for certificates of indebtedness denominated in Hong Kong dollars. These certificates are non-interest-bearing and are issued and redeemed at the discretion of the Financial Secretary. They provide the legal backing for the notes issued by the banks (apart from their small 'fiduciary' issues-these are limited to a total of $95 million) and are issued against securities, of a kind approved by the Secretary of State, which are held by the banks and deposited with the Crown Agents in London. The fund's resources are invested in a variety of securities, both long and short-term, denominated in sterling and other currencies. Out of the income derived, the fund bears the cost of the note issue except for a small proportion, equivalent to the proportion borne by the 'fiduciary' issues to the total note issue, which is met by the note-issuing banks. In practice, from 1937 to 1968, the Exchange Fund operated in a similar manner to traditional Colonial Currency Boards.
The exchange value of the Hong Kong dollar was established in 1935 at approxi- mately 1s 3d. On the setting up of the International Monetary Fund after World War II, the Hong Kong dollar was given its own gold parity at a rate reflecting this relationship. The relationship with sterling was, however, not a statutory one, and was established and maintained by the operations of the Exchange Fund in con- junction with the note-issuing banks. Nevertheless, it came to be generally regarded as a fixed relationship. Hong Kong, as both a dependent territory and a member of the sterling area, was required in practice to keep its official reserves, and the greater part of the reserves of the banking system, in the form of sterling.
Thus, when sterling was devalued by 14.3 per cent in November 1967, Hong Kong suffered a substantial loss estimated at £50 million. After an immediate devaluation of the same proportion, the Hong Kong dollar was revalued by 10 per cent four days after the British move, making a final devaluation of 5.7 per cent. This did not reduce in any way the loss to the community; rather it determined where the loss would fall. The cost to Hong Kong's public funds amounted to $450 million, including compensation paid from the Exchange Fund to commercial banks against their consequential losses.
These events finally made it clear that the old relationship with the pound was no longer appropriate to Hong Kong's economic situation. On the other hand, it was not possible for Britain to allow any significant diversification of Hong Kong's sterling assets (amounting then to £350 million) into other currencies, in view of her own depleted reserves; while at that stage she was not prepared to offer guarantees of the international value of sterling reserves.
However, following negotiations in London, a novel arrangement was intro- duced in June 1968, whereby Hong Kong was allowed to use its sterling assets to purchase British Government bonds, of seven years maturity, denominated in Hong Kong dollars. These bonds were purchasable to a value of £100 million or 50 per