TNAG-2466-FCO40-3590-Economic-situation-in-Hong-Kong-1992 — Page 48

CODE 18.77

Mr Stone HKD

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Bein inconventions well.

amorted

The Linked Exchange Rate

Furness'

12/6.

Reference..................

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GENERAL By MS

Mr Furness asked for comments on the above draft brief for Mr Patten's office.

1.

2.

In Para 2 after first sentence I would suggest replacing the rest of the paragraph with;

The most important features of the system are as follows:

a)

Two note issuing banks, Hong Kong and Shanghai Banking Corporation and Standard Chartered, receive a certificate of indebtedness (CI) for each US dollar they have deposited with the Exchange Fund. The CI authorises the issue of 7.8 Hong Kong dollars by the note issuing banks. The US dollars held by the exchange fund constitute a part of Hong Kong's foreign exchange

reserves.

b) Hong Kong has two interelated foreign exchange markets: one between the Exchange Fund and commercial banks featuring the fixed rate of HK$7.80 per US dollar, and the other between commercial banks and the public featuring free market rates.

c) The free market rates cannot depart significantly from $HK 7.80 per dollar as long as banks are allowed to trade between the two markets. For example a rise in the free market rate above HK$ 7.8 per US dollar would induce banks to surrender US dollars to the Exchange Fund for HK dollars which could be resold to the non-bank public for a profit. The actions of the banks would be reversed if there is a fall in the free market rate below HK$7.80 per US dollar.

3.

And then in place of paragraphs 3 and 4 add;

The linked exchange rate to the US dollar also disciplines the level of local interest rates which, in general, will remain close to US interest rates. If however there were a loss of confidence in the linked rate, Hong Kong interest rates would rise above US interest rates until the interest rate gap is sufficiently high to compensate for the perceived extra risk attached to holding Hong Kong dollars rather than US dollars. Similarly local interest rates cannot fall far below US interest rates unless there is an expectation of appreciation against the US dollar i.e. the prospect of a future capital gain is sufficient to encourage people to hold Hong Kong dollars even though interest rates payable are lower than on US dollars.

4.

Add a sentence at the beginning of paragraph 5 as follows;

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