Origins of the Chinese Hyperinflation; J. Habegger

In the case of the Chinese inflation, this question has been largely overlooked. Most au thors who have chronicled the inflation have focused on events which occurred after the Na tionalists managed to obtain control of the cur rency. 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 oper ated thoughout China, although the largest Chi nese banks and all the foreign-owned banks were based in Shanghai. Some provincial gov ernments controlled their own banks, but they had to maintain the same standards as private banks in order to compete. Mr. Habegger is a student at the University of Colorado in Boulder. He was a summer intern at FEE in 1986. Privately held banks operated like any other Chinese business and competed with one an other 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 de preciating currencies-and instances of banks' inflating their currencies were extremely rare.3 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 insuring the political and financial support of the largest Chinese banks. Eventu ally, the banks would become dependent on the government. The final step was to bring Chi nese banks under direct control of the Nation alists, removing all barriers to currency control.

In 1927, the process began when banks got caught in the political split between the Nation alists 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 Kai-shek saw an opportunity to bolster the fi nancial position of his new government. He struck a deal with the bankers which stipulated that Chiang would suppress the strikes, in re turn for loans to the Nationalist government.

Believing that a Nationalist victory would be more favorable to their businesses than a Com munist success, and anxious to protect their loans to the Nationalists, the banks became a quick source of funds for the Nationalist gov ernment, 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 Nation alists, 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 sub versive or have his property confiscated. Reliance on Deficit Financing The reason the Nationalists needed bank loans was their heavy reliance on deficit fi nancing. Widespread taxation was politically unattractive as well as an administrative night mare. 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 per cent of government revenue.4 And the government continued to in crease its debt without any way of servicing it.

To prevent the bankers from becoming polit ically disaffected and to maintain long-term fi nancial 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 Nation alist government to offer large quantities of se curities. To insure purchase, the securities car ried high interest rates and were sold at sub stantial discounts from their face values. For example, the government sold securities in 1931 at little more than 50 per cent of their face values.5 Thus, the Nationalists postponed their financial problems until the bonds came due. CHINESE HYPERINFLATION 363 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 rev enue, such as customs taxes or salt taxes. Be cause of the incentives, the rate of return on government securities was far greater than any thing the bankers could have obtained on sim ilar 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 govern ment monopoly over the issuance of notes.6 At the outset the bank was primarily an ex tension 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 pri vate banks to the board of directors of the Cen tral Bank, although the board actually held little power.

The market for government bonds was sup ported by the Chinese banks. By 1932, Chinese banks located in Shanghai held between 50 per cent and 80 per cent of outstanding government bonds.? As intended, the banks were financially bound to the Nationalist government. Govern ment activities had a large effect on the values of banks' assets, so that the relationship be tween 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.8 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 364 THE FREEMAN. SEPTEMBER 1988 dropped to less than 60 per cent of face value, which represented a severe loss for banks holding a large amount of bonds.9 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. 10 While the Nationalists tried to end the au tonomy of the banks by binding them to the government, the final blow to Chinese private banking came from the United States. Begin ning .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 mone tary value of the gold stock. 11 Although the Silver Purchase Act was in tended primarily as a commodity support pro gram 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 per cent; by the middle of 1935 the price had tri pled. 12 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 layoff 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. Un able to foresee the actions of the U.S. Con gress, businessmen had assumed debt which appeared to be a prudent risk. Now they had more debt than they had bargained for. Of Chiang Kai-shek at time of attempt to organize war against Japan, c.1936. 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 Nation alist .government imposed export controls on silver .. The export controls proved unsuc cessful, 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 govern ment to seek new revenue sources. It granted the Central Bank special privileges, such as ex emption 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 be came the most profitable financial institution in China. Although it held only 11 per cent of the assets of all Chinese-owned banks, it earned 37 per cent of all banking profits in 1934.13 Most of the Central Bank's profits were used to fi nance 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 re quired each savings bank to purchase govern ment 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 finan cial situation, the largest private bank, the Bank of China, attempted to loosen its ties to the Nationalists. The Bank of China began li quidating 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 govern ment bonds would follow. If the bond market collapsed, the Nationalists would be unable to continue the policy of debt financing. In des peration, the government began to look for an other solution to its financial problems.

Rather than cut expenditures, the new fi nance 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 in terest. The propaganda worked. Irate citizens 'voiced oppositionto 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 emer gency loans would be made to ailing busi nesses. But Kung's concern for failing busiCHINESE HYPERINFLATION 365 nesses was largely a front. His primary concern was the financial condition of his employer, the Nationalist government. The propaganda cam paign 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 re placed them with government appointees. In June 1935, the Nationalist government used resources from the two banks to gain con trol 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 govern ment banks simultaneously presented them for redemption. Since the banks were unable to re deem 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 re placed with political appointees.

The End of Private Banking By July 1935, the Nationalist government had ended private banking in China. The re sources of the Chinese banks were at the Na tionalists' disposal, since they held a majority interest in each bank. No time was wasted in using these resources to finance the govern ment. 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 defla tion. Businesses continued to fail as more silver 366 THE FREEMAN. SEPTEMBER 1988 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 pun ishable by death or life imprisonment.14 Still, the deflation continued. With the end of private banking, Kung pro posed to institute a managed currency backed by nothing more than government promises.

The switch to a paper currency was intended to benefit the government in two ways. First, all silver in China would come under the govern ment's direct control. With government control of silver and the help of a "Currency Stabiliza tion 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 gov ernment issued the Currency Decree.15 Effec tive 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 jai-pai or Chinese National Currency, was to be managed by the Central Bank of China. The notes of pri vate banks were allowed to continue circulating in fixed amounts, although they were to be gradually phased out. All institutions and indi viduals who owned silver were ordered to ex change it for the new currency within six months.16 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 for eign 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. 17 Also, the Decree main tained that "plans of financial readjustment have been made whereby the National Budget will be balanced. "18 And, according to Finance Minister Kung, "The government is deter mined to avoid inflation.... "19 The w'ording of the Decree was the govern ment's attempt to quell fears of inflation. Chi nese 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 modem banking system. But, despite the pro visions 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 gov ernment 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 in flation 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 unparal leled in history. D 1. Chang Kia-Ngau, 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: 1937-1945 (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. 4. Ibid., p. 66. 5. Eduard A. Kann, The History o/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 Nation alist Government, 1927-1937 (Cambridge: Harvard University Press, 1981), p. 74. 8. Ibid., p. 77. 9. Ibid., p. 91. 10. Ibid., p. 95. 11. Milton Friedman and Anna J. Schwartz, A Monetary History 0/ the United States, 1867-1960 (Princeton: Princeton University Press, 1963), p. 485. 12. Friedman and Schwartz, p. 490. 13. Coble, p. 171. 14. W. Y. Lin, The New Monetary System o/China (Shanghai: Kelly and Walsh Publishers, 1936 [reprinted by the University of Chicago Press]), p. 73.

15. Ibid., p. 78. 16. Ibid. 17. The Currency Decree of November 3, 1935. 18. Ibid. 19. Ibid.