TNAG-1347-FCO40-1777-Financial-policy-in-Hong-Kong-1984 — Page 31

SECRET

Risks

7. It will, of course, be costly for the Exchange Fund to have to pay the very high interest rates its own HK$ borrowing has led to, but the burden also falls on those whose debts have market-related interest payments. The principal fear must be that if this higher level of rates were necessary for any length of time, already over- extended borrowers - particularly the property companies - would be unable to service their debts, leading to the danger of further insolvency in the financial sector which undertook the initial V lending.

8.

If a strong sentiment develops that 7.80 cannot be defended, and that a downward adjustment, or reversion to floating is inevitable, even very high levels of interest rates will not discourage the taking of speculative positions against the currency, which themselves result in further pressure. If, for example, I believe that in a week the HK$ will be at 8.50 against the US$, an annual interest rate of around 400% would be needed to prevent me wanting to switch out of an interest-bearing HK$ account into the US$ now (400 = 52 times the potential capital loss in foreign currency terms).

Options

9.

i) the HKG could undertake more direct intervention, maintain the 7.80 peg, and hope confidence returns, before the effects of high interest rates become insupportable;

ii) given that the US$ is gaining value against all currencies, not just the HK$, it could

a) adjust the peg downwards; or

b) change to a peg defined in terms of the trade-weighted index; or

iii) abandon the peg and adopt a genuinely hands-off policy, leaving the exchange rate to finds its own level.

10. Markets in the Territory are nervous enough at present that the third option is probably too dangerous. The disruptions of a long slide in the HK$, and periods of market breakdown with no buyers for the currency, would be extremely damaging.

11. A downward revision of the peg would lead to suspicions that this step would be repeated, and might make matters worse rather than better. The adverse effects on inflation through higher import prices should not be ignored. A shift to a peg against the trade-weighted index at its current level, say would prevent the HK$ having to follow the US$ up against other currencies. The current 'mechanism' need not be abandoned Certificates of Indebtedness would be valued and tradeable against the US$ (between the note-issuing banks and the Exchange Fund) at a variable rate depending on its value against the other currencies in the basket. Simplicity would be lost, but there is much to be said for this alternative peg.

12.

In terms of trade-related transactions, the present level of the trade-weighted index is clearly not inappropriate given 1984's excellent export performance. The problem is that attempts to switch into the US$ as part of capital export linked to political uncertainty could swamp these trade-related demands, so this move would not remove the root problem.

/13.

SECRET