Mr. Habegger is a student at the University of Colorado in Boulder. He was a summer intern at FEE in 1986.
Between 1935 and 1949, China experienced a hyperinflation in which prices rose by more than a thousandfold. The immediate cause of the inflation is easy to isolate: the Nationalist government continually injected large amounts of paper currency into the Chinese economy. The monetary expansion was so severe that during World War II, Nationalist printing presses were unable to keep up, and Chinese currency printed in England had to be flown in over the Himalayas.
A prerequisite for any sustained inflation, however, is monopoly control of the money supply. In the absence of a monopoly, individuals simply will switch to a competing currency when one becomes inflated. Thus, a key question in the study of any inflation is how the state obtained monopoly control.
In the case of the Chinese inflation, this question has been largely overlooked. Most authors who have chronicled the inflation have focused on events which occurred after the Nationalists managed to obtain control of the currency. Let us thus examine how the Nationalist government gained monopoly power over the Chinese currency.
Prior to 1935, China enjoyed a limited free banking system. Privately owned banks operated throughout China, although the largest Chinese banks and all the foreign-owned banks were based in Shanghai. Some provincial governments controlled their own banks, but they had to maintain the same standards as private banks in order to compete.
Privately-held banks operated like any other Chinese business and competed with one another to obtain customers. Most banks issued their own notes, which were redeemable in silver, the traditional medium of exchange in China. The notes from each bank circulated freely with the notes from other banks. Perhaps most noteworthy is that Chinese banks operated largely without state regulation. A free banking system has inherent checks against inflation—primarily because customers will flee from depreciating currencies—and instances of banks’ inflating their currencies were extremely rare.
The arrival of the Nationalist government in 1927 started a long process to eliminate free banking in China. By 1935, the Nationalists had succeeded. Rather than outright seizure, they followed an incremental approach to gain control of the currency. The first steps were aimed at ensuring the political and financial support of the largest Chinese banks. Eventually, the banks would become dependent on the government. The final step was to bring Chinese banks under direct control of the Nationalists, removing all barriers to currency control.
In 1927, the process began when banks got caught in the political split between the Nationalists and the Communists. Violent strikes led by Communist labor leaders crippled industry in Shanghai. When the bankers appealed to the Nationalist Party to stop the strikes, Chiang Kalshek saw an opportunity to bolster the financial position of his new government. He struck a deal with the bankers which stipulated that Chiang would suppress the strikes in return for loans to the Nationalist government.
Believing that a Nationalist victory would be more favorable to their businesses than a Communist success, and anxious to protect their loans to the Nationalists, the banks became a quick source of funds for the Nationalist government, as well as staunch supporters, even while their freedom to operate was being eroded.
Eventually the bankers became leery of lending more funds to the Nationalists. The government appeared to be a financial black hole, and the bankers were skeptical of its ability to service its debts. When the bankers refused to extend more loans to the Nationalists, Chiang used the same methods against the bankers that he had used against the strikers. A banker who wouldn’t supply more loans might be thrown in jail as a political subversive or have his property confiscated.
Reliance on Deficit Financing
The reason the Nationalists needed bank loans was their heavy reliance on deficit financing. Widespread taxation was politically unattractive as well as an administrative nightmare. Under these circumstances, Chiang saw deficit spending as the most expedient method to finance his government. For example, in 1927, the first year of the Nationalist regime, loans accounted for 49 percent of government revenue. And the government continued to increase its debt without any way of servicing it.
To prevent the bankers from becoming politically disaffected and to maintain long-term financial support, Chiang’s Finance Minister and brother-in-law, T. V. Soong, promoted a policy of “cooperation” with the bankers. Soong’s aim was to further tie the bankers to the fate of the Nationalist government.
In the spring of 1928, Soong began to put his plan into action. He arranged for the Nationalist government to offer large quantities of securities. To ensure purchase, the securities carried high interest rates and were sold at substantial discounts from their face values. For example, the government sold securities in 1931 at little more than 50 percent of their face values. Thus, the Nationalists postponed their financial problems until the bonds came due.
The bankers were aware of the potential problems with the bonds, so to make them even more salable, the securities were guaranteed. Each issue was backed by a government revenue, such as customs taxes or salt taxes. Because of the incentives, the rate of return on government securities was far greater than anything the bankers could have obtained on similar investments in private concerns.
Soong also set out to develop a system of public finance patterned after Western nations. In 1928 he founded a central bank, the “State Bank of the Republic of China,” although he hadn’t as yet been able to establish a government monopoly over the issuance of notes.
At the outset, the bank was primarily an extension of the Nationalist Treasury, although it did issue its own notes. While the Central Bank primarily handled the revenue of the Nationalist government, it also competed with private banks for business. The revenues of the bank were used to purchase government bonds. To enhance the bank’s image and further tie other private banks to the Nationalist government, Soong appointed many of the directors of private banks to the board of directors of the Central Bank, although the board actually held little power.
The market for government bonds was supported by the Chinese banks. By 1932, Chinese banks located in Shanghai held between 50 percent and 80 percent of outstanding government bonds. As intended, the banks were financially bound to the Nationalist government. Government activities had a large effect on the values of banks’ assets, so that the relationship between the Nationalists and the banks grew even closer. Commonly, Nationalist officials who controlled the issuance of government bonds would sit on the boards of private banks. Having inside information, many government officials became extremely wealthy trading in government securities.
The financial events following the Japanese invasion of the Chinese mainland in January 1932 illustrate just how closely the banks were tied to the Nationalist government. When the Japanese force landed, a panic spread through the bond market and a rush developed to unload government securities. Within five days of the invasion, the average price of government bonds dropped to less than 60 percent of face value, which represented a severe loss for banks holding a large amount of bonds. Fearing that the notes of some banks soon would become irredeemable, panic spread and there were “runs” on some banks; at least two Chinese banks failed due to the crisis.
While the Nationalists tried to end the autonomy of the banks by binding them to the government, the final blow to Chinese private banking came from the United States. In 1933, the U.S. began to purchase large amounts of silver, and in June 1934 the Silver Purchase Act was passed. This Act instructed the United States Treasury to purchase silver until the world price of silver rose above $1.29 per ounce, or until the monetary value of the U.S. silver stock reached one-third the monetary value of the gold stock.
Although the Silver Purchase Act was intended primarily as a commodity support program for silver producers in the United States, it had an enormous effect in China. As a result of the U.S. legislation, the world price of silver jumped rapidly, and from early 1933 to the end of the year the price of silver rose by 75 percent; by the middle of 1935 the price had tripled. Since almost every bank note in China was backed largely by silver, the U.S. silver buying program triggered a sharp deflation in China. The appreciated silver caused exports to shrink while imports rose, which produced a net outflow of silver. The banks sold their silver abroad, withdrew notes from circulation, and slowed the rate of new note issue.
The declining supply of bank notes caused each note left in circulation to appreciate in value, leading many businesses to experience accounting losses. With prices falling, selling prices often could not meet the previous costs of inputs. The losses caused many businesses to lay off workers and cut production.
Also, many businesses carried some debt. The loans were made in non-deflated currency, but now had to be paid back in deflated money. The real value of the debt ballooned while the businesses had less cash flow to service it. Unable to foresee the actions of the U.S. Congress, businessmen had assumed debt which appeared to be a prudent risk. Now they had more debt than they had bargained for. Of course, the Nationalists also were feeling the adverse effects of the deflation. Their policy of debt financing suddenly became an even greater burden.
In an effort to stop the deflation, the Nationalist government imposed export controls on silver. The export controls proved unsuccessful, and the smuggling of silver became an occupation in itself. Much silver was smuggled through foreign-owned banks, since they were immune from Chinese regulations.
The desperate financial situation wrought by the deflation prompted the Nationalist government to seek new revenue sources. It granted the Central Bank special privileges, such as exemption from silver export controls, so that the Central Bank was able to earn large revenues while private banks were struggling. Because of government patronage, the Central Bank became the most profitable financial institution in China. Although it held only 11 percent of the assets of all Chinese-owned banks, it earned 37 percent of all banking profits in 1934. Most of the Central Bank’s profits were used to finance the Nationalist regime.
Despite export controls and the revenues of the Central Bank, throughout 1934 the financial situation of the Nationalist government became increasingly worse. In an attempt to sell more government securities, the Nationalists issued the Savings Bank Law. This legislation required each savings bank to purchase government bonds until its holdings of such bonds represented one-fourth of total deposits. But even the Savings Bank Law failed to have a significant effect on the Nationalists’ financial position.
Perhaps because of the government’s financial situation, the largest private bank, the Bank of China, attempted to loosen its ties to the Nationalists. The Bank of China began liquidating its holdings of government bonds at a loss. Since many smaller banks tended to follow the Bank of China, the Nationalists were worried that large-scale liquidation of government bonds would follow. If the bond market collapsed, the Nationalists would be unable to continue the policy of debt financing. In desperation, the government began to look for another solution to its financial problems.
Rather than cut expenditures, the new finance minister, H. H. Kung, in consultation with Chiang Kai-shek, devised a scheme to harness the resources of the largest banks to further underwrite the Nationalist government. Instead of making the securities themselves more attractive, Kung intended to seize outright control of the two largest private banks in China, the Bank of China and the Bank of Communications.
The first step was to initiate a propaganda campaign against the bankers, essentially blaming them for China’s economic problems. Kung asserted that business failures, caused by the deflation, were a result of the banks’ placing their own profits above the public interest. The propaganda worked. Irate citizens voiced opposition to the banks, and Chinese newspapers ran editorials supporting Kung’s charges.
Public opinion and Kung’s urging persuaded the banks to establish a fund from which emergency loans would be made to ailing businesses. But Kung’s concern for failing businesses was largely a front. His primary concern was the financial condition of his employer, the Nationalist government. The propaganda campaign was designed to sway public opinion in favor of government seizure of the Bank of China and the Bank of Communications.
On March 23, 1935, Kung announced that the Nationalist government would seize control of the two banks. Kung gave the takeover the appearance of legality by arbitrarily creating enough shares in each bank for the government to become the majority stockholder. Instead of using the emergency fund to aid businesses, it was used to partially pay for the shares of the banks. The rest was financed with a nominally equivalent value of government securities. Kung removed the old bank officials and replaced them with government appointees.
In June 1935, the Nationalist government used resources from the two banks to gain control of some of the smaller private banks. Kung ordered the three government banks—the Bank of China, the Bank of Communications, and the Central Bank of China—to hoard the notes of several smaller banks in Shanghai. When they had amassed a substantial quantity of the notes of the smaller banks, the three government banks simultaneously presented them for redemption. Since the banks were unable to redeem all the notes at once, Kung declared the banks to be insolvent and immediately seized control. He insisted that the government would manage them in the public interest. Again, the officials of the banks were removed and replaced with political appointees.
The End of Private Banking
By July 1935, the Nationalist government had ended private banking in China. The resources of the Chinese banks were at the Nationalists’ disposal, since they held a majority interest in each bank. No time was wasted in using these resources to finance the government. The banks were directed to purchase government securities and to advance loans. But even with the resources of China’s largest banks, the Nationalist government was barely able to remain solvent.
The banking coup had no effect on the deflation. Businesses continued to fail as more silver was smuggled out of China. In a futile attempt to stop the deflation, the Nationalists made the smuggling of silver out of China a crime punishable by death or life imprisonment. Still, the deflation continued.
With the end of private banking, Kung proposed to institute a managed currency backed by nothing more than government promises. The switch to a papercurrency was intended to benefit the government in two ways. First, all silver in China would come under the government’s direct control. With government control of silver and the help of a “Currency Stabilization Fund” created by the United States and Great Britain, it was believed that the deflation could be stopped. Second, the government would have monopoly power over the money supply, so that it would be possible to monetize the government debt.
On November 3, 1935, the Nationalist government issued the Currency Decree. Effective the next day, only notes issued by the three largest government banks—the Bank of China, the Bank of Communications, and the Central Bank of China—were to be legal tender in China. The new currency, called the fai-pai or Chinese National Currency, was to be managed by the Central Bank of China. The notes of private banks were allowed to continue circulating in fixed amounts, although they were to be gradually phased out. All institutions and individuals who owned silver were ordered to exchange it for the new currency within six months.
To preserve confidence in the new currency, the Decree contained provisions to establish a “Currency Stabilization Fund.” The Fund was to buy and sell foreign exchange in order to keep the exchange rate of the Chinese currency approximately constant, relative to certain foreign currencies. The Decree also contained provisions to alter the function of the Central Bank. Instead of merely being an arm of the Nationalist Treasury, the Central Bank was to become a “banker’s bank,” distinct from the Nationalist Treasury. Also, the Decree maintained that “plans of financial readjustment have been made whereby the National Budget will be balanced.” And, according to Finance Minister Kung, “The government is determined to avoid inflation . . . .”
The wording of the Decree was the government’s attempt to quell fears of inflation. Chinese newspapers ran editorials assuring the public that the Nationalists had nothing but the best intentions for the Chinese economy, and the move to a paper currency was heralded by economists around the world as a step toward a modern banking system. But, despite the provisions of the Decree, the Central Bank was never removed from the Treasury’s control. Even more fraudulent was the assurance that the budget would be balanced. Indeed, the government deficit increased in the years following the currency reform.
In retrospect, Kung’s statement seems like a cruel joke on the Chinese people. The currency reform destroyed the private banking system which had served the Chinese economy well, and placed control of the currency in the hands of a corrupt and inept government. Inflation began almost immediately. Eventually, the inflation became so severe that it helped bring about the collapse of the Nationalist regime. Thus, monopoly power over the currency proved fatal to the Chinese economy, since the inflation that Kung was “determined to avoid” occurred with a severity and length unparalleled in history.
1. Chang Kia-Ngan, The Inflationary Spiral: The Experience in’ China, 1939-1950 (New York: John Wiley & Sons, 1958), p. 372.
2. Arthur N. Young, China’s Wartime Finance and Inflation: i937-I945 (Cambridge; Harvard University Press, 1965), p. 159.
3. Mitsutaro Araki, “Economic Trends and Problems in the Early Republican Period,” in Report on the Currency System of China (New York: Garland Publishing Inc., 1980), p. 18.
5. Eduard A. Kann, The History of China’s Internal Loan Issues (New York: Garland Publishing Inc, 1980), p. 82.
6. Lien-sheng Yeng, Money and Credit in China (Cambridge: Harvard University Press, 1952), p. 90.
7. Parks M. Coble Jr., The Shanghai Capitalists and the Nationalist Government. 1927-1937 (Cambridge: Harvard University Press, 1981), p. 74.
11. Milton Friedman and Anna J. Schwartz. A Monetary History of the United States, 1867-1960 (Princeton: Princeton University Press, 1963), p. 485.
12. Friedman and Schwartz, p. 490.
14. W. Y. Lin, The New Monetary System of China (Shanghai: Kelly and Walsh Publishers, 1936 [reprinted by the University of Chicago Press]), p. 73.
17. The Currency Decree of November 3, 1935.