TNAG-1347-FCO40-1777-Financial-policy-in-Hong-Kong-1984 — Page 30

CODE 18-77

Mr_Hoare,

HKD

SECRET

Reference

НСК

100/3

EIVED IN REGISTRY

17 JUL 1984

22

HK$ THE HKG RESPONSE; PROSPECTS

1. The HK$ ended last week with a further fall away from the 7.80 link level, reaching 7.867 on 13 July (see Figure 1). The prime rate has increased by just over 3 percentage points to 17%, and the three-month money market rate is around 25%.

The link mechanism

2.

theory

1

In this year's budget, Mr Bremridge spoke of 'an automatic monetarist adjustment mechanism', noting that ... the currency scheme transfers the pressure on the exchange rate arising from any shifts into or out of the Hong Kong dollar initially on to interest rates.' The idea was that because note-issuing banks were guaranteed US$ at the 7.80 rate when they cancelled HK$ banknotes. Should the HK$ weaken to 7.85, say - there would be an incentive for this to occur and for profitable transactions of the following type to take place:

―

i) Note-issuing bank cancels HK$ 100 million;

ii) Receives US$ 12.82 million from the Exchange Fund in return for Certificates of Indebtedness (at 7.80); and

iii) Buys HK$ in the market at 7.85, receiving HK$ 100.64 million a profit of over half a million HK$.

3. If note-issuing banks allow other banks to receive US$ for HK$ notes at the 7.80 rate, it would be they who could gain the profit. Other banks, such as the Bank of China, transact in HK$ banknotes with the issuing banks at this rate.

4.

This would ease pressure on the exchange rate in two ways:

—

the fall in the HK$ money supply would raise interest rates, increasing the demand for HK$ in interest-bearing deposits; and

―

the selling of US$ itself would tend to raise the value of the HK$. (Note that if people expect the HK$ to fall further, they may see a greater return in holding onto the US$, and not realising the immediate profit.)

The link mechanism

-

practice

5. Telno 1929 from Hong Kong suggests that some operations of this type have been taking place, but that the loss of US$ holdings has been at the expense of the note-issuing banks and not the Exchange Fund, The Exchange Fund has been borrowing HK$ in the money markets so as to force up interest rates.

6. Other recent telegrams have noted that direct intervention in the foreign exchange markets has been undertaken in the attempt to hold the US$ above 7.82. It would seem that the HK monetary authorities have not wished to put the mechanism to the test, but instead have acted to raise interest rates themselves, and so increase the demand for HK$. There are various difficulties associated with this strategy.

SECRET

/Risks

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