Please convey the following to the Prime Minister  for his Most Secret and Personal information. BEGINS.
CHINA Chiang Kai Shek  indicated in putting forward Anglo-Chinese proposals set out in my telegram Circular Z. 350  that effects of Japanese air raids this summer and of price inflation in China are so serious that unless he could receive assistance from the United States and us, he would be unable to maintain his resistance to Japan beyond the end of this year and that China would then have to extract herself from her difficulties as best she could.
2. Our financial commissioner in the Far East  considers that the seriousness of the price situation has not been overstated.
The likelihood of Chiang's giving in soon is difficult to assess but we believe his supply situation to be deteriorating and we know that Japan is endeavouring to detach Russia and to get into direct negotiation with Chiang Kai Shek. It would seem therefore that a gesture of support is in fact needed to hearten the Chinese resistance.
3. Chiang Kai Shek's proposals have accordingly been sympathetically considered by Cabinet. It was agreed that in view both of increasing pressure on Indo China (see Circular Z. 364 ) and of other indications that Japanese may be preparing for a move southwards against British and Dutch territory, it was in our vital interest that Chinese resistance should be maintained. From this it follows that our policy should be to give China as extensive help as we can consistent with our own war effort and without provoking Japan prematurely into war.
4. As regards Chiang Kai Shek's specific proposals, our views are as follows:-
5. Paragraphs (1) (2) and (3) of my Circular Z. 350: Similar proposals have now been made to United States (see my Circular telegram Z. 365 ) and we shall wish to discuss them with them when more exact details are known and the United States Government have had time to consider them. We cannot expect, however, that the United States will be willing to enter into definite commitments at this stage and this seems to rule out anything in the nature of an alliance. Some joint or parallel declarations may well be possible but as they are bound to cover ground which has on several occasions been covered by statements of the United States Government and ourselves, we feel it is better in the first place to work out such concrete help as may be feasible.
6. (a) in last paragraph of Circular Z. 350: Loan sums as large as those mentioned by Chiang Kai Shek would be beyond our capacity, although the United States may be willing to add to previous credits on a larger scale than hitherto. We have, however, received more limited proposals through the Chinese Ambassador in London  for a currency stabilization loan up to 5 million and additional export credits of the same amount for purchases anywhere in the sterling area. It is evident that Chinese desire these credits in the first place for political reasons as a token of our support of China's cause. Having regard among other considerations to the fact that assistance has been given to China by us in this form already and that it is at the same time a measure of assistance to Far Eastern interests generally, we consider reactions in Japan are likely to be less than to any other form of direct assistance, especially as the United States have also given credits and may give more. Cabinet have therefore decided in principle to grant China a loan for currency purposes and a credit for sterling purchases, subject to the views of the Dominion Governments and satisfactory overcoming of technical difficulties.
7. Since China is long of sterling at present, the Treasury view is that to give her more sterling unconditionally would result in increased sales of sterling on Shanghai market and a fall in sterling-United States dollar rate there, which would result in increased evasion of our control through Shanghai, to the detriment of our exchange position. This would also react on the Chinese dollar. As regards export credits to cover purchases in sterling area, position is that export credit of three million pounds granted in 1939 for purchases in the United Kingdom has not been fully expended owing to difficulty in meeting Chinese requirements from the United Kingdom without detriment to our own war effort. It would seem however that important, even if less urgent, requirements could be met from sterling area as a whole. A fuller list of requirements is therefore being sought from Chinese in order to determine whether this would be feasible.
8. To meet exchange difficulty, Treasury contemplate making in agreement with the Chinese Government, arrangements under which sterling held by Chinese residents will be available for expenditure in sterling area only. If this can be done, financial assistance could be given to China without weakening our exchange position. Subject to this condition and to the further examination of Chinese requirements, the idea we have in mind is to make a further advance to stabilisation fund not exceeding five million pounds and to agree to export credits for Chinese purchases in sterling area with a maximum of three million pounds or possibly five million pounds.
9. (b) in last paragraph of Circular Z. 350: We are not in a position to provide aeroplanes (except possibly a few of obsolescent type as to which we are making enquiries). Almost all United States production of up to date types is absorbed either by United States or by ourselves. It is possible however that the United States might be able to supply obsolescent types which would be of little use to ourselves but might be of use against the Japanese. There is the further point that the Chinese have placed orders in the United States of which they have not yet been able to obtain delivery. These points will be discussed with the United States Government in due course.
10. (c) in last paragraph of Circular Z. 350: If financial assistance is granted to China it might be of advantage to follow it up with an economic mission or by providing technical experts, but we think it better that these should not precede concrete help. Meanwhile we are proposing to Chinese Government that a mission should go to Chungking from Burma to discuss the problems directly affecting Burma. We do not propose for the present that a military mission should be sent, though we are considering the creation of a nucleus of such a mission to be held in readiness in case we were involved in hostilities in the Far East. Meanwhile we are also considering replacing our Military Attache in China by a more senior officer and strengthening his staff. Through this channel unobtrusive discussions can be held with the Chinese of a technical character.
11. We should welcome your views before proceeding with the proposals outlined above.