China’s New Vassal
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FOR many years following the disappearance of the old Manchu Empire in 1911 the growth of any real central authority in China was impeded by the country's lack of fiscal resources. The successive governments in Peking were unable to finance the essential services of the state properly, and were weak and ineffective. But the National Government which was set up at Nanking in 1927 succeeded to a remarkable degree in developing an adequate financial system. This fact -- added to the vigor, leadership and wide appeal of the Nationalist movement -- enabled that Government to make rapid progress in rehabilitating China. And in the future, as in the past, we may be sure that finance will play a major part in shaping the course of events in China.
I. A DECADE OF PROGRESS, 1927-37
The attainment of tariff autonomy in 1928-30 tripled China's revenue from customs. This, together with the rehabilitation of the salt revenue administration and the development of a system of internal taxation on such things as tobacco, cotton yarn, flour, liquors and mineral products, increased the total revenue from customs and these other sources from $369,000,000 in 1929 to $618,000,000 (Chinese currency) in 1931. The needs of the new Government, however, were too urgent to be met wholly by developing tax revenues, a matter of months and years. It was equally important that the market for public loans should be developed, in order to obtain funds needed for defense against subversive movements and for internal economic reconstruction. This was facilitated by the growth of the Government's revenues and by the rise of modern banks, notably at Shanghai, which was becoming one of the world's great financial centers. Although there were deficits every year from 1927 to 1937, it was possible to keep them within manageable limits. Even though the budget had not been balanced by 1937, when the present conflict broke out, substantial equilibrium was by then in sight.
A reform of the currency was an essential prerequisite to real progress. In 1929 the Kemmerer Commission stated that China had "unquestionably the worst currency to be found in any important country of the world." Nevertheless the medium of exchange was gradually becoming more uniform through the increasing use of the silver dollar and dollar bank notes. The abolition of the tael as a standard of value in 1933 established the dollar system throughout most of China. There remained, however, the highly difficult problem of the silver standard.
Unquestionably China's adoption of a managed currency in November 1935 was a major event in the recent history of the Orient. This reform created a foreign exchange standard by which the Chinese dollar was to be maintained at about 29½ cents (United States currency) and 14½ pence sterling, by means of exchange operations on the part of the Chinese Government banks. Silver was to be nationalized and a fiduciary currency substituted. And the Central Bank of China was to be converted into a Central Reserve Bank.[i] The reform was facilitated by the helpful action of both the American and British Governments. The latter issued an Order in Council prohibiting British subjects in China from making payments in silver. The American Treasury bought a substantial amount of Chinese silver; and this and subsequent purchases have been an indispensable aid to China in carrying out the scheme and in maintaining the exchange value of her currency. Meanwhile a decimal system of nickel and copper coins was introduced, supplanting the old heterogeneous coins.
In this way China acquired essential elements of a modern currency system, linked at a favorable level with the systems of the Western countries and Japan. But this was not all. China increased her financial strength very materially in other ways. Most of the silver was removed from the coast cities, where it was vulnerable to seizure, and converted into gold and bank balances abroad, where they were available to make foreign purchases and to support the currency. The stabilization of exchange at a level adapted to the country's needs led to a favorable balance of payments, so that large amounts of foreign exchange were bought and added to currency reserves. Moreover, the transition from a metallic to a fiduciary currency was effected smoothly; and this made it possible to expand China's currency and credit if necessary in an emergency. The heavy outlays required by the hostilities could not have been financed on a hard money basis; and under conditions as they existed, a transition from the silver standard to a paper currency could scarcely have been made without a serious shock to confidence. All these developments provided effective resources and financial machinery without which China's stubborn resistance to Japan's attack would not have been possible.
Economic reconstruction required foreign capital; but large-scale foreign investment was impossible so long as a large part of the old debts of the Peking régimes remained in default. The National Government took this problem in hand, and by July 1937 had made settlements covering most of the amount in arrears. These settlements, in conjunction with the other financial policies of the National Government, caused a notable improvement in the quotations of Chinese loans: in mid-1937 several leading issues were quoted on the London market at par, or even above, and yielded less than five percent. China's credit was becoming such that a large influx of foreign capital was in prospect to finance the vast reconstruction work so sorely needed.
Interrelated with all these developments was the marked improvement which took place in China's internal political situation. By mid-1937 the National Government apparently had ended any serious challenge, from either local warlords or Communists, to its program of establishing a moderate régime on a nation-wide basis. The Japanese military caste, it seems clear, attacked China in the summer of 1937 precisely because China's strength was growing so rapidly.
II. CURRENCY AND EXCHANGE SINCE THE BEGINNING OF HOSTILITIES
When the armed conflict broke out in North China on July 7, 1937, the Central Bank of China was in a strong position. Ever since the reform of November 1935 the Chinese dollar had been stable, the Central Bank having enhanced confidence by meeting without difficulty a number of raids on the currency. An immediate effect of the July 7 affair was a flight of Chinese funds abroad, a movement which continued during the uncertainties of the next five weeks. The outbreak of fighting at Shanghai on the morning of Friday, August 13, 1937, precipitated a financial crisis, and a bank holiday till the following Monday was declared. Emergency measures had to be worked out amidst the turmoil of nearby fighting. To prevent a run on the Chinese banks and to check the flight of capital, the Government restricted the withdrawal of deposits. A limited quantity of blocked currency -- wei wah -- was created, comprising bank funds usable only for transfer and not convertible into cash. By this means a general moratorium on payments was avoided. Such special regulations, however, could not be applied to the foreign banks, because of the régime of extraterritoriality and because of the existence of foreign settlements and concessions. A gentlemen's agreement therefore was made with the foreign banks to the effect that they would sell exchange only for legitimate trade and personal requirements, and would not accept new accounts or any material increase in the old accounts of Chinese customers. With these measures in force, the markets were able to reopen in an orderly manner on Monday, August 16.
These steps checked the flight of capital and tightened the money market, and during the ensuing autumn exchange rates held steady. It was realized, however, that a renewed demand for exchange would soon appear, due to the lag in demand for import exchange. The technical position was this: the Shanghai fighting had largely stopped trade, but the exchange derived from exports already shipped had been sold in the market, whereas many of the imports had been financed on credit and the exchange had yet to be bought. As expected, this demand began to materialize about November 1. After running at a substantial figure for some weeks it steadily fell off, and by mid-February was drying up.
At this juncture the Japanese announced the creation of a puppet bank for North China -- the so-called Federal Reserve Bank -- to open in March and to issue notes for circulation in that area. As a countermeasure the Government decided to withdraw its direct support from the general exchange market, and instead to grant weekly allotments of foreign exchange to meet legitimate demand. At first, round sums were granted to the banks; but shortly thereafter allotments were made only after considering specific individual applications for legitimate import and personal requirements.
Because of lack of full jurisdiction over foreigners and in the foreign settlements and concessions, and in view of the extent of the areas affected by Japanese interference, the Chinese authorities were not in a position to apply general measures of financial control such as other countries have put in force. The system of exchange allotments was adopted as the best available substitute. By this means the open market rate of exchange was left free, and through adjustment of the amount of exchange allotted in the light of actual market conditions, the rate was allowed gradually to fall to about 60 percent of the level prevailing before the conflict without seriously impairing confidence in the currency.
As soon as it appeared that intervention in the market could be effective, operations were cautiously begun to stabilize the open market rate. Though these operations were successful, it was apparent that still greater resources were required. In the spring of 1939 it proved possible to arrange with the British Government on favorable terms for the creation of the Sino-British Stabilization Fund of £10,000,000. Chinese and British banks contributed to it in equal proportion.
From the outset the Fund had to face difficult conditions. In April 1939 the Japanese announced the creation of the Hua Hsing Commercial Bank at Shanghai as a bank of issue for their puppet régime in Central China. This announcement caused disturbances on the market which continued through May. Meanwhile an adverse balance of payments had been developing, and early in June the Fund temporarily withdrew support and allowed the rate of exchange to drop about 20 percent. Before confidence could be restored, the Japanese announced the blockade of the Tientsin concessions; they also declared their intention of preventing the circulation of Chinese currency in those concessions and of taking over the North China silver reserves. Such nervousness developed that the Fund was confronted not only with exchange difficulties but with a run on the banks. During the latter part of June the strain became so great that fresh restrictions on withdrawals from Chinese banks had to be imposed. The restrictions temporarily tightened the market, but by the latter half of July the pressure had again increased to such an extent that the authorities had to permit the exchange rate to fall still lower.
This time stability was longer in returning. By the middle of August, however, the market had become quieter and steadier, and the prospect materially improved. The outbreak of the European war started a repatriation of Chinese funds from Europe. This movement, plus the fact that exchange rates had swung so low as to be considerably out of line with China's internal conditions, caused a rise in the Chinese dollar during the fall of 1939. In mid-November it stood in Shanghai at about 9 cents (U. S.) and about 5¼ pence sterling.
In North China the Japanese have forbidden the use of Chinese currency in the areas they control, chiefly the leading cities and the railway zones. In those regions the "Federal Reserve notes" of the puppet bank circulate: their actual market value is sometimes below and sometimes above that of the Chinese currency. In the Tientsin concessions the Chinese currency circulates, and also in the extensive areas of North China where the Japanese occupation does not extend and where the puppet notes are forbidden. In the "occupied" areas of Central and South China, the circulation consists of Chinese currency but includes some yen and military notes forced out by Japanese troops. About three million notes (with a nominal value of 6 pence) of the puppet "Hua Hsing Commercial Bank" circulate, chiefly in the Hong-Kew district of Shanghai.
Free exchange rates are much more sensitive to disturbing influences than general prices, and the level of internal prices in China has not risen in anything like the proportion in which exchange has fallen. Prices in particular cities are not typical of the entire country since they are affected by local influences -- in coastal cities by Japanese interference with normal trade and the large use of imported goods, and in some of the larger interior cities by the Government's abnormal demand for supplies and labor. Throughout a wide area prices of many important articles of consumption have risen little or not at all. Though no accurate estimate is possible, a good guess is that throughout China the average of prices has gone up by around 60 or 70 percent. Fortunately for China, several years of excellent crops (except recently in North China) have mitigated the hardships resulting from the Japanese invasion.
China's maintenance, despite Japanese interference, of a free exchange market in which legitimate business can be conducted has benefited both her own and foreign interests. The substitution of a Japanese-controlled monetary system in the "occupied" areas would mean setting up a closed economy in which foreign trade could be carried on only on Japanese sufferance.
III. PUBLIC FINANCES
China's public finances have suffered severely from the seizure and destruction of her sources of revenue by the invading forces. The Japanese occupation of one port after another has deprived the Government of the greater part of its customs revenue. Important salt-producing areas have been invaded, thus interfering with its salt revenue. Income from other internal taxes has fallen off, since they were collected largely along the seaboard.
The Chinese Government has been unable to replace these losses by new taxation, not only because Japan has occupied so many important cities, but also because China has not yet developed a relatively productive system of direct taxation. Elasticity of tax yield is hard to obtain even under the most favorable conditions, and especially when indirect taxes form the main source of revenue. China only recently began to introduce income, inheritance and profit taxes; though these have been extended during the hostilities, their yield could meet only a small part of China's present great needs.
The Chinese Government has thus had to borrow large sums, beginning with the Liberty Loan of $500,000,000 (Chinese), issued in the early weeks of the conflict. The total amount of the loans authorized up to November 1939 was about $2,800,000,000 (Chinese). The numerous Chinese living overseas -- in the United States, the Philippines, the Straits Settlements and elsewhere -- have generously subscribed to these bond issues, and have also made substantial patriotic donations.
The borrowing program has been smoothly carried out with the coöperation of the banks. Fiscal theory recommends that extraordinary wartime needs be financed largely out of revenue; nevertheless, experience has shown that where this is not possible the emergency can be met for a considerable period by relying largely upon borrowing. China's borrowing, however, has considerably increased her bank-note circulation and deposit credit. The note issue of the four Government banks, plus that of the Canton area (which was taken under the wing of the Government shortly before hostilities began), grew from $1,643,000,000 to $2,866,000,000 (Chinese) from the end of June 1937 to the end of June 1939, according to the latest published figures. A part of this increase represents the substitution of notes for silver coins and the purchase of gold within China.
In a world where disregard for international obligations is becoming ever more widespread, China's foreign debt record in recent years has been exceptionally good. The National Government, soon after it came into existence, undertook to settle the debts in arrears inherited from the old Peking régimes. After unsuccessfully trying to arrange a general settlement with all its creditors, it embarked on a program of negotiating with them individually. Despite many difficulties, arrangements were effected for the resumption of payments on most of the bond issues in arrears at terms which reflected both China's desire to pay in accordance with her capacity and the reasonableness of the creditors. By mid-1937 the Government had negotiated settlements of debts totalling about $850,000,000 (Chinese), or around $250,000,000 (U. S.). About two thirds of the total value of claims arising from loans were thus settled, including nearly all of the publicly issued bonds. Had peace and economic improvement been allowed to continue, an understanding about remaining unsettled items would doubtless have been reached in due time.
After July 1937 the course of events gradually affected the debt situation. By 1937 the Chinese Government was paying the Japanese portion of the Boxer Indemnity into a special account (in pounds sterling) in a neutral bank, to be held for future disposition. During the fall of that year efforts were made to devise some scheme whereby customs revenue might continue to be applied to debt service despite Japan's seizure of the ports. No such scheme had been agreed upon, however, when in October the Japanese forced the Commissioner of Customs at Tientsin to deposit collections in the Yokohama Specie Bank under conditions which made it impossible to use them for debt service, unless perhaps on terms which the Chinese could not accept. When Shanghai was captured in November 1937, collections there were similarly tied up; and the process was repeated as other ports fell into Japanese hands.
The object of the British Government in negotiating a customs agreement with Japan in the spring of 1938 was to maintain, so far as possible, the historic Chinese customs service and to provide a basis for continued service of China's debts despite hostilities. The best terms to which the Japanese would agree included the deposit of collections in Japanese banks, and payment to Japan of past and future installments of her share of the Boxer Indemnity. They also insisted that the proportionate monthly contributions, which according to the agreement were to be made by the occupied ports for China's debt service, should cover only foreign, not domestic, loans (only those were involved that were outstanding before hostilities). Further, the entire burden of providing foreign currency for the debt service would have rested upon the Chinese Government, despite Japan's interference with its currency.
Affirmative action by the Chinese Government was necessary before this agreement could become operative. The Government, however, was not prepared to implement the agreement on these terms; and despite prolonged efforts to find a formula, it was not put into effect. Nevertheless, the Government duly continued service of the debt in spite of the fact that the Japanese were detaining considerably more than half of the pledged customs revenue. The shortage of collections was made good by advances to the Inspector-General of Customs from the Central Bank of China, advances which by January 1939 totalled $175,000,000 (Chinese). In addition, the Chinese Government provided all the foreign exchange required for debt service.
Clearly this situation could not go on indefinitely. In January 1939 the Chinese Government very reluctantly announced that it could no longer continue to advance funds for service of interest on issues; and in March 1939 this policy was extended to salt-secured issues. Nevertheless, since then the Government has been setting aside in the Central Bank of China -- in Chinese currency -- a share of the long-time debt service.
To have kept up the service of her external bond issues for over eighteen months after the larger part of the pledged revenues had been seized, and in spite of the tremendous strain which the war placed on the country's most important productive areas, has been for China a worthy accomplishment, one which its creditors abroad will not soon forget. This is a bright spot in the recent record of debtor countries.
V. THE FUTURE
The Japanese invasion came at a time when China was completing a decade of rapid internal progress. On the record, the Japanese cannot rightly pretend that they invaded China in order to improve conditions. Their slogan -- the "New Order in East Asia" -- is only a phrase to cloak their twofold object of dominating China in their own interest and of expelling Western influence from the economic and cultural life of that country.
A leading Chinese strategist once remarked that China yielded space in order to gain time. In many respects time is on China's side. Nevertheless, nearly two and a half years of bitter hostilities have been weakening to China as well as Japan. Tens of millions of people have been driven from their homes. Throughout huge areas internal production and trade and external commerce are throttled by Japanese interference, while large parts of North China are threatened with famine owing to recent floods. China's financial structure is naturally showing the effects of this strain. Impaired revenue and heavy emergency expenditures leave the budget unbalanced. The foreign exchange value of the currency has fallen to around a third of its pre-hostilities level, although fortunately in the country as a whole the level of internal prices has not risen alarmingly. Losses from destruction of property and from economic disruption have been widespread. Yet despite everything, China carries on amazingly with her economic life, due to her decentralized and predominantly agricultural organization and the resourcefulness and tenacity of her people.
In the past, material assistance from friendly countries has been of great value to China in maintaining her economic and financial structure. The credit of $25,000,000 which the American Export-Import Bank granted in December 1938 to a Chinese trading corporation has made possible the purchase of much-needed commodities in the United States. The British credit of £5,000,000 of March 1939 has aided in maintaining the value of the Chinese currency. Russia also has granted important credits, in considerably larger amounts, for the purchase of Russian supplies.
Japan is now eager to end the "China incident," but there is no indication of an early end to the fight. Assuredly it is in the interest of China's Western friends that there be no avoidable weakening of China's financial front.
[i] A plan for the latter was agreed upon at the end of June 1937 after long discussion, but was not placed in effect because of the outbreak of hostilities a few days later.
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