Hyperinflation in China, 1937 - 1949
Till 1927, China had a free banking system through the interaction of private banks operating in various regions of the country. 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.
These 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 rare.
Rise of Chiang's Nationalists
Chiang Kai-shek's Nationalist Party came to power in Nanking in 1927. They initiated a long process to eliminate free banking in China. Violent strikes led by Communist labour leaders crippled industry in Shanghai. When banks appealed to the government for aid, Chiang Kai-shek struck a deal that his government would suppress the strikes in exchange for bank loans. This put the banks in the position of supporting the Nationalists to protect their loans against the Communists.
The nationalists favoured using bank loans to finance their programs instead of unpopular and administratively difficult taxation. In the first year, loans accounted for 49% of the government's revenue. (Report on the Currency System of China, 1980)
Eventually, banks became concerned about the government's ability to service its blossoming debt let alone repay. When bankers refused to loan additional funds, Chiang used the same tactics he employed against the strikers - the perpetrator was thrown in jail as a political subversive and/or had his property confiscated.
In 1928, Chiang's Chief Finance Minister and brother-in-law, T.V. Soong, formed the Central Bank of China that was effectively an extension of the Treasury. The Central Bank began to offer the private banks large quantities of bonds guaranteed and backed by government revenue from custom taxes that carried high rates of interest. These bonds did not fix the financial situation, in fact they made it much greater, but they did delay the repayment time.
In September 1931 Japanese forces seized control of Manchuria and established the puppet regime Manchukuo. The loss of Manchuria, and its vast potential for industrial development and war industries, was a blow to the Nationalist economy. The government bonds now sold for little more than 50 percent of their face value. (The History of China's Internal Loan Issues, 1980).
By 1932, Chinese banks located in Shanghai held between 50 percent and 80 percent of outstanding government bonds. (The Shanghai Capitalists and the Nationalist Government, 1927-1937, 1981)
To enhance public image, Soong appointed many of the directors of private banks to a symbolic board of directors of the Central Bank that in reality had very little power. Nationalist officials who controlled the issuance of government bonds often gained seats on the boards of private banks gaining much personal fortune in the process.
Silver Leaves China for the U.S.
In 1934, the U.S. passed the Silver Purchase Act that enabled the U.S. Treasury to buy up silver. The result was a tripling of the silver price due to the increased demand exerted by the Treasury. Massive amounts of silver flowed out of China to the U.S. sparking a deflationary recession. In 1934 the gross domestic product for China fell 26%.
The appreciation of the yuan during the deflationary period resulted in the burden of debt to become even greater. In October 1934, the Nationalist government imposed foreign-exchange controls to limit the silver exports. All this achieved was in silver being smuggled through foreign owned banks that were immune from Chinese regulations.
The Nationalist government granted the Central Bank special privileges, such as exemption from the silver export controls. Subsequently, the Central Bank became China's most profitable financial institution in 1934, earning 37 percent of all banking revenue while accounting for only 11 percent of the total banking assets in China. (The Shanghai Capitalists and the Nationalist Government, 1927-1937, 1981)
Seizure of Private Banks
In light of deteriorating finances, the Nationalists issued the Savings Bank Law which required each private bank to purchase government bonds until they represented one-fourth of total deposits.
The largest private bank, the Bank of China, decided to sever its ties with the Nationalists and began selling its holdings of government bonds at a loss. In order to prevent a wide-spread bond market collapse, the Nationalists began a propaganda campaign against the bankers. It blamed China's economic woes on the private bankers who placed their profits above those of public interest.
Public opinion persuaded the banks to form a fund from which emergency loans would be made to failing businesses. On March 23, 1935 the Nationalist government seized control over the two largest private banks - the Bank of China and the Bank of Communications. They did this by using the money collected in the emergency fund and through issuance of additional government bonds to purchase enough stock to become the majority shareholder.
They then used the resources of the three banks under their control to takeover smaller private banks. They then began a strategy where they would hoard notes of the smaller banks in Shanghai. When they had amassed a sufficient quantity, they would simultaneously present them to the targeted bank and demand redemption in silver. Since the bank was unable to redeem all the notes at once, it was deemed to be insolvent and immediately seized so that it could be managed with regard to the 'public interest'. All officials of the banks were removed and replaced with political appointees.
By July 1935, the Nationalist government had effectively ended private banking in China as it was the majority shareholder in each bank. The resources of the Chinese banks were used to finance the government through the continued purchase of government bonds.
But even with the resources of China's largest banks, the Nationalist government was barely able to remain solvent. Businesses continued to fail as more silver was smuggled out of China. The Nationalists made the smuggling of silver out of China a crime punishable by death or life imprisonment. (The New Monetary System of China, 1936)
Establishment of Fiat Currency
On November 3, 1935 the Central Bank of China announced the Currency Decree and officially took the country off the silver standard and placed the country on a fiat currency. With a complete monopoly over the money supply, the Nationalists could monetize their debt.
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. (The New Monetary System of China, 1936)
The move was heralded by economists around the world as a step toward a modern banking system. It was, in fact, the start of a process that would help pave the way to communist ascension in China. With an inept and corrupt government in control of the Chinese money supply inflation occurred almost immediately.
Massive monetary inflation occurred from July 1937 to September 1945 to fund the war with Japan. It is estimated that 65 to 80 percent of the annual expenditures were covered by newly printed money.
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. (China's Wartime Finance and Inflation: 1937 -- 1945, 1965)
Resumption of Civil War
The end of conflict with Japan reopened the longstanding civil war between Chiang Kai-shek's Nationalist government and the large communist forces led by Mao Zedong. Mao's support had grown immensely due to the economic hardships endured by the people in response to hyperinflation. It destroyed the wealth of the middle class and drove many segments of the rural population into severe poverty. Price and wage controls imposed by the government during this time only exacerbated the problem by creating even more distortions and imbalances.
The civil war raged across China for four years and money creation continued unabated, covering some 50 to 65 percent of the government's spending.
Mao's communists were triumphant on the mainland and the remnants of Chiang's Nationalist army withdrew to Taiwan in late 1949. The new government created a new yuan to replace the old depreciated yuan at a conversion rate of three million to one bringing the total money supply to 296.8 billion yuan. However, once again the money supply grew exponentially to 8,186.3 billion by December 1948 and in April 1949, the money supply reached 5,161,240 billion yuan.
Foreign exchange markets reflected the huge devaluation of the yuan. In June 1937, 3.41 yuan traded for one USD. By December 1941, on the black-market 18.93 yuan exchanged for a USD. At the end of 1945, the yuan had fallen to 1,222. By May 1949, one USD fetched 23,280,000 yuan for anyone who cared to have some.