TNAG-0456-FCO40-521-Reports-and-accounts-of-Exchange-Fund-of-Hong-Kong-1974 — Page 6

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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.

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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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