TNAG-2515-FCO40-3669-Future-of-Hong-Kong-International-Rights-and-Obligations-Sub-1992 — Page 13

E.

CONFIDENTIAL

4 -

rates have supported the buoyancy of private investment and consumET

spending and have thereby intensified inflationary pressures.

Thus, while

the objective of maintaining financial stability continues to justify the

commitment Lo the exchange rate anchor, eschewing the use of monetary and

exchange rate policy inevitably imposes a greater burden on other policy

instruments in containing demand pressures. We would note that persistent

high inflation rates in an environment of low global inflation would lead to

a deterioration in the competitiveness of Hong Kong's manufacturing and

externally-oriented service industries, and could eventually undermine the

credibility of the exchange rate anchor, particularly in the event of an

unfavorable external shock.

We continue to believe that fiscal policy should play a key role in

containing domestic demand, A prudent fiscal policy in past years has

resulted in the accumulation of large fiscal reserves, These reserves are

essential for maintaining confidence, given Hong Kong's vulnerability to

external shocks and the commitment to the exchange rate anchor. Notwith-

standing the relatively small size of Government in Hong Kong, sharp changes

in the net savings-investment balance of the public sector would translate

into excessive claims on resources available to the economy.

small and

open economy as Hong Kong's, part of the change in the Government's demand

for resources will be met through higher imports. However, part of it will

also be reflected in a change in overall demand for limited domestic

resources which, in the context of full employment, will intensify price

pressures. Indeed, the marked reduction in the budget surplus from 1988/89

In a