"He reacted immediately. He said, `No - I could send troops in this afternoon if you don't agree'.
"I said, `Yes, you can - there is nothing I can do to stop you because you have only to go over the border but the world would know what China was like and how she dealt with these affairs'."
However, Lady Thatcher said on BBC's Breakfast with Frost that she was "a cautious optimist" over the future of Hong Kong and urged people to give the new administration a chance.
The former prime minister regretted that, for the first time, Britain would hand over a dependent territory which would then enjoy less democracy. "This must be the first time as the pages of history turn to go from dependence on Britain to dependence on another country has meant cutting democracy," she said.
Lady Thatcher, who signed the Joint Declaration in 1984 agreeing to the handover of Hong Kong, said she hoped for a "certain amount of restraint" on all sides.
"Let's give the new administration a chance. Let's give the people the chance to show that they are reasonable - they will want to know how much liberty they have. They should still have a right of demonstration; they will have to apply to the police and the police should give it, because the Hong Kong people demonstrate with a great deal of dignity."
She also disclosed that in her talks with Deng in 1982, the Chinese leader asked her to stop the flow of money out of Hong Kong, which was then taking place. His insistence that she had the power to do so showed that he had no understanding of the Western system of the rule of law, freedom and justice.
"I said, I can't. He had no concept that we could be the governing authority and not have the powers to make them do as we said. That is the whole difference between life governed by a rule of law administered independently, and life governed under the dictatorship of Communism."