WHEN Japan invaded China in 1937, China's monetary system was prepared for the emergency. It can be said without exaggeration that were it not for the new monetary system which was introduced in November 1935, China could not have withstood the Japanese onslaught in the initial period of the war. A clear understanding of the new system and a knowledge of the way it has operated during the war are a necessary precondition for a fruitful discussion of the problem of the postwar adjustment of Chinese currency.

The importance of the new monetary system can best be suggested by a reference to the chaotic condition of the currency in the days of the Peking Government and during the early years of the National Government. As late as 1929, the report of the Kemmerer Commission stated that "China has unquestionably the worst currency to be found in any important country of the world." The major tasks of currency reform were the establishment of a uniform and convenient medium of exchange and the adoption of a monetary standard. In 1933, the first and comparatively easier problem was solved by the abolition of the tael and the adoption of the standard silver dollar as China's monetary unit. The much more difficult problem of the monetary standard was solved in November 1935 by the abandonment of the silver standard and the adoption of a managed currency.

The circumstances which precipitated the adoption of the new monetary system are of much more than academic interest. Now, when China's central financial problem is rising prices, it is interesting to recall that, although inflation is most undesirable, its immediate impact does not create difficulties as acute as those produced by deflation. The rise in the world price of silver after 1931, stimulated by the British devaluation of the pound and later to a greater degree by the American silver purchase program, led to a sharp fall in prices in China. Prices in Shanghai fell more than 30 percent from the summer of 1931 to the summer of 1935. The wave of failures of businesses and banks, the unemployment, and the stagnation of trade in the period 1933-35 are still vividly remembered in China. These developments sealed the doom of the silver standard. In October 1934, just a year after the writer was appointed Minister of Finance, China divorced the value of its currency from silver by imposing an export duty and a variable equalization charge on outward movements of silver. This step checked the tendency of the exchanges to appreciate, a movement which was exerting serious effects on China's exports, and prepared the way for reform of the currency.

This epochal reform, which was announced on November 3, 1935, made the yuan, or Chinese dollar, fapi, or legal tender. Silver was nationalized; the use of silver dollars as currency was prohibited and fapi could not be converted into silver. The value of fapi was to be kept stable by the three government banks -- the Central Bank, the Bank of China and the Bank of Communications -- which could buy and sell foreign exchange in unlimited quantities. In order to sustain confidence, note issue was carefully controlled and the government banks' reserve against note issue was required to be at least 60 percent in gold, silver and foreign exchange, the balance to consist of government bonds and other approved securities. By 1937, when Japan began the present war, the external reserve against note issue had increased to more than 70 percent. Foreign exchange rates were successfully stabilized and free convertibility into foreign exchange maintained until March 1938, when a limited degree of exchange control had become necessary as a measure of economic warfare. It was at that time that Japanese puppet banks in occupied China began to issue currency with which to purchase fapi, planning to convert it into foreign exchange.

The new system contributed materially to the restoration of prosperity in China, and by doing so it facilitated other measures of financial reform, most of which had been initiated before 1935. These included the strengthening of revenues and the restoration of credit through the reorganization of the internal and external debt. It enabled us to obtain a favorable balance of payments which, together with the sale of silver, brought about the accumulation by China of large balances of foreign exchange. These stood China in good stead in the war of resistance. Last but not least, it enabled the government to rely on the increase of bank credit as a means of emergency war finance. Thus, despite the lack of modern equipment in the military field, the new monetary system provided China with modern means of financing war.

Partly as a result of advance in monetary technique throughout the world, the technique of war finance, like that of war itself, has made rapid progress in the last 30 years. Under the older monetary systems, when bank notes were convertible on demand into hard cash, a considerable increase of issue to meet a government's deficit tended to cause not only a fall in the purchasing power of the notes, but also their depreciation in terms of coin. This depreciation always had a direct and often very serious effect on public confidence, and the rise and fall of the premium on specie measured the public's estimate of the fortunes of war and the government's financial prospects. Thus the old technique of war finance commonly involved measures of inflation that directly and quickly impaired morale. For instance, during the American Civil War, a considerable part of the war expenditures was covered by direct issue of government paper money which almost immediately went to a discount in terms of gold. By 1914, however, central banking systems were in operation in most of the leading countries, and upon the outbreak of the First World War, systems of managed currency were promptly introduced. These systems made it possible to finance war expenditures by means of loans from government banks.

Had the old silver standard persisted in China, the transition to a managed currency could not have been made, under war conditions. Silver would have gone to a premium over bank notes, which would have rapidly depreciated, and an early monetary breakdown would have resulted. Moreover, the large silver reserve kept by the banks for the purpose of meeting the public's demand for convertibility would have stayed mostly at Shanghai and other coastal cities, subject to enemy seizure. The reform of 1935 unified the monetary system on a managed currency basis with an exchange standard, and prepared the way for emergency expansion of currency and credit.


During the course of seven and a half years of war, China was forced to resort more and more to emergency expansion of currency and credit in order to bridge the gap between the needs of the government, particularly for war and reconstruction, and the revenue which could be raised by taxation and borrowing from the people. The government, of course, did its best to restrict expenditures and to raise as much revenue as possible from taxes and public loans. The loss of customs revenue, the major part of the salt levies, and the consolidated taxes on manufactured products greatly reduced the income of the government. But the government developed several important new sources of revenue.

The outstanding wartime fiscal innovation was the reorganization of the land tax. As a result of careful planning, culminating in the Third National Financial Conference in June 1941, the land tax was transferred from the provincial authorities to the National Government, which reorganized it on the basis of collections in kind. The successful collection of land tax in kind, together with obligatory sales of food to the government by landowners, has placed more than 50,000,000 piculs of foodstuffs at the government's disposal annually. This has been used to feed the Army and government employees, and also to stabilize the price of rice and wheat, the most important daily necessities. The collection of this tax requires a large and elaborate apparatus with ramifications extending down to the village. Since the coöperation of the village functionaries was necessary, certain abuses were inevitable; these local leaders lacked the training and the discipline of the National Government's officials. But many of the abuses have been eradicated and further remedial measures are being devised and applied.

The development of direct taxation included another important wartime fiscal reform -- the broadening of the scope of the income tax, which had been initiated before the war. An excess war-profit tax was introduced on January 1, 1939, an inheritance tax on July 1, 1940, and a wartime consumption and sales tax in 1942. The unification of national and provincial finance also yielded additional revenue, besides strengthening the Central Government politically. Prior to the war, we had instituted a budgetary system and established the Office of the Comptroller-General and a national auditing system, thereby ensuring a modern system of independent supervision over receipts and expenditures. Among various reforms in fiscal administration which continued the process of modernization, the most significant was the introduction of the Public Treasury System on October 1, 1939. This provided that all public funds were to be handled by the National Treasury, with the Central Bank of China acting as the custodian. These progressive measures resulted in such a substantial increase in the tax yield that in 1943 between 40 percent and 50 percent of government expenditures were met by income.

Like all countries at war, China was obliged to expand its expenditures rapidly. Not only did she have to raise and support large armies, but the enemy's invasion made it imperative for the government to take immediate and large-scale action to open new means of communication, to develop industries to supply the armies with vitally needed munitions, and to provide the public with necessities formerly obtained from abroad or from regions occupied by the enemy. Beginning in 1942, the strain on the Chinese economy was increased by the growing expenditure of the United States Army in China. This involved large fapi outlays. According to the principles of sound finance, the gap between large and mounting expenditures and receipts from taxes should be bridged as far as possible by loans subscribed by the public. But, during the last six years, it has been difficult to raise funds in this way in China because of the loss of the leading centers of wealth and trade.

Thus, the main difference between China's war finance and that of some other countries does not lie in the smaller share raised by taxation; as indicated above, the proportion of government expenditures covered by tax revenue in China is comparatively high. The difference lies rather in China's inability to raise the greater part of the deficit through loans from the public. Under the circumstances, the government could not avoid borrowing most of its funds from the banks and from abroad.

Some private foreign credits for war needs were obtained early in the war, although the amounts were relatively small. The period of substantial borrowing began in 1938 with the American wood oil loan and Russian barter credits, followed early in 1939 by the first British stabilization credit. Loans from the Allies, which to date have amounted to about one billion United States dollars, have been of the greatest value to China in sustaining her war effort. Part of these loans has already been repaid. The United States $25,000,000 wood oil loan was repaid two years and a half before it matured; and the United States $50,000,000 stabilization credit of 1941, only a small part of which was drawn upon, and the 5,000,000 pound British stabilization credit of 1941, have also been paid. We are also shipping goods to Soviet Russia to liquidate our obligations under the barter agreement. The largest single items of Allied financial assistance to China, arranged after the outbreak of the Pacific war, are the United States $500,000,000 loan and the British credit of 50,000,000 pounds. Two-fifths of the United States $500,000,000 loan were used as backing for the issuance of United States dollar certificates and victory bonds, which were sold to the public. The double purpose of the issuance of these securities was to check inflation by absorbing fapi, and to provide merchants and manufacturers with means of purchasing equipment and supplies after the war for industrial reconstruction and development. Part of this loan was used to purchase gold, which is being sold to the public. The quantity of fapi absorbed by these means, however, does not bridge the gap, and it is necessary to borrow rather heavily from the government banks.

This method of emergency finance, therefore, carries with it an unavoidable inflationary tendency. The inflation can be checked to some extent by various controls of trade, production, consumption and prices, and foreign exchange. But effective control of a country's economy is possible only when the economy is centralized and its system of governmental administration complete and highly integrated. But China's economy is dominantly agricultural and largely decentralized. The development of the necessary railways and other modern means of communication is far from complete. While the National Government had made great strides in the administrative organization and unification of the country in the decade prior to 1937, the task was a tremendous one and was still unfinished at the beginning of the war. And, most important of all, the seizure by Japan, in the early period of the war, of leading centers of finance, where most of China's modern industries are concentrated, forced Free China to move its economic and financial base to the economically less developed interior provinces in the southwest and northwest. Under these conditions, such elaborate and comprehensive controls of production, consumption and prices as are now in force in the western countries could not be effectively applied throughout China. Control of foreign exchange can, of course, be carried out with some effectiveness. But without strong internal control of production, prices and consumption, control of foreign exchange inevitably produces a divergence in the internal and external values of the currency.

Such a divergence developed markedly in China after the middle of 1940, when the shortage of goods began to be keenly felt. The severance of the Indo-China route and the temporary closing of the Burma Road, the loss of Ichang, and the relatively poor crops in 1940 resulted in a great scarcity of goods. The war in the Pacific which began in 1941, and the Japanese conquest of Burma in 1942, led to an almost complete cessation of China's international trade. This reduced the supply of goods still more and heightened the fear of very grave commodity shortages. Inevitably, prices rose further. One of the major causes of rising prices in China is simply the shortage of goods. This is partly evidenced by the fact that commodity prices vary considerably from one locality to another.

In studying the problem of prices in China, it is important to remember that China's decentralized and predominantly agricultural economy has also proven a source of strength; the process of inflation has been much more gradual than it would have been in a more integrated economy. China's largely rural population has managed to adjust itself to price increases with less hardship and suffering than would have been the case in industrialized countries.

The official rate of exchange of fapi was fixed by the Stabilization Board of China in August 1941 at .05 11/32 United States dollars; this was changed to .05 United States dollars as of July 10, 1942. Since July 1942, the government has persistently followed a policy of maintaining the exchange rate in order not to weaken confidence in the currency and provide speculators with an excuse for further boosting prices. Under conditions of blockade, with foreign trade practically non-existent, no benefit that can be derived from lowering the rate would counterbalance the harm that might result from further loss of internal confidence and its unfavorable impact on internal prices. However, in order to lighten the hardship of foreign residents and others in China, the government granted a 100 percent subsidy (40 fapi instead of 20 for one United States dollar) to missionary, philanthropic and relief organizations, journalists and foreign government and other foreign personnel, and for emigrant remittances from abroad.

Those who argue in favor of a change of the rate by citing the theory of "purchasing power parity" overlook the fact that even in normal times the theory requires various qualifications. It must be remembered that the index numbers in the countries compared are based upon different kinds of goods, and include many articles of local use which do not enter into foreign trade. And in applying the theory, allowance must be made for obstacles to free interchange of goods, such as transportation charges, tariffs and controls. In China today, with ordinary trade stopped and exchange controlled, the usual interaction of internal and external prices and exchange rates is blocked. The black market, which unfortunately exists wherever there is exchange control, is very narrow; both the amounts of foreign currency (mostly United States dollars) supplied, as well as those demanded, are small and sporadic. Neither the estimate calculated on the basis of purchasing power parity nor the black market rate indicates the true external value of fapi.

Therefore, no one can say what exchange rates are theoretically correct for China at present. As for the future, when the occupied territories are recovered, the enormous quantities of Japanese and puppet currencies now in circulation in these regions will be wiped out, and a large quantity of fapi will be needed to fill the vacuum thus created. The confidence of the people of the occupied regions in the currency is shown by the fact that it is being hoarded in considerable quantities by the peasants, in spite of the severe coercive and punitive measures adopted by the Japanese against the practice. Confidence is also reflected in the rapid appreciation of fapi in terms of puppet currencies in occupied China. If this confidence is maintained, the task of readjusting the currency will be greatly facilitated. It is yet too early to prescribe in detail what steps of readjustment should be taken. But the prospect of victory is sufficiently close, and the shape of things to come sufficiently clarified, to make it possible to outline the basic principles for the solution of China's postwar monetary problems.


First of all, it is essential to remember that stabilization of internal prices, determination of the level of exchange, and rehabilitation of the public finances are intimately related. Without relative internal price stabilization, rates of exchange and the balance of payments cannot be maintained in equilibrium. And without substantial equilibrium in the budget, price stabilization will not be possible. Solution of all these problems is, in turn, closely bound up with the question of the restoration of the country's internal economy -- in particular its production and transport facilities -- and the rehabilitation of its foreign trade. Monetary and fiscal reform in China therefore depends upon the speed with which the work of relief and rehabilitation is undertaken; and it demands a many-sided program of economic reconstruction. The task will have to be approached from many angles at the same time. This analysis can merely list in summary fashion certain of the basic steps:

(1) A program of relief and rehabilitation, to be carried out in coöperation with UNRRA, should be put into practice as soon as transportation facilities are available and as soon as parts of occupied China are liberated. The program should be designed to help restore China's internal economy by augmenting the supply of goods, both through the importation of relief supplies and by taking action to enable China to increase her own production.

(2) Effective measures to reduce government expenditures must be adopted as soon as possible. In order to accomplish this difficult but supremely important objective, it may be necessary to abolish certain wartime agencies and reorganize both civil and military branches of the government in the light of peacetime needs and on a basis of strict economy. In planning government expenditures for economic reconstruction, careful consideration should be given to China's financial situation and the vital importance of restoring equilibrium in the budget. President Chiang called attention to this important principle in a recent address to the Conference on Planning of Industrial Reconstruction. The quickest and surest way to initiate a sound program of reconstruction will be to make certain that its cost does not interfere with the restoration of sound finance.

(3) Government income must be increased by the restoration of fiscal services in the occupied areas and the reorganization of the revenue system. The national income will rise rapidly when China is able to begin producing again. Thus with a wise plan of taxation, built on the foundations that have been laid in wartime, and with proper attention paid to the further development of a sound system of administering taxes, there need be no concern about the possibility of raising adequate revenue. The revenue will be sufficient for the current needs of the central, provincial and local governments and will provide a sound fiscal basis for economic and cultural growth.

(4) Japan should be made to pay with raw materials and goods as well as with her gold, silver and foreign exchange for the damage she has inflicted on the Chinese people. Such reparations from Japan can greatly assist China in her program of reconstruction and in her task of monetary rehabilitation. A plan should likewise be worked out to force Japan to shoulder as much as possible of the burden of liquidating the enormous quantity of Japanese and puppet currencies issued in China. Naturally, the Chinese Government will not recognize these notes and cannot pledge a cent of the Chinese taxpayers' money for their redemption. But among the holders of the notes are innocent Chinese who had the currency forced on them and who should not be made to suffer a total loss. Under the circumstances, the most equitable solution is to make the Japanese, the puppet governments, officials, and the other collaborators who have enriched themselves by squeezing the people, foot the bill.

(5) The Chinese system of banking and credit should be further reformed. In particular, the Central Bank should be strengthened in order to accommodate the banking structure to the requirements of the postwar period. In order to enable the Central Bank to discharge the functions of a full-fledged bankers' bank, it should be made to maintain its stand as an independent institution and its powers should be expanded on the lines indicated in the charter which was adopted -- but not promulgated -- in 1937, a recent revision of which has just been drafted. Furthermore, the modern private banks, the native banks and the system of agricultural credit must be reorganized in conformity with postwar needs. In view of the extent to which certain financial institutions are involved in commodity speculation -- despite government regulations to the contrary -- serious losses and many failures will inevitably result when the price rise is checked and the period of financial readjustment sets in. There will, therefore, be a real need for reform of the banking system to facilitate production and trade and to encourage formation of private capital.

(6) Appropriate measures should be adopted to improve China's international balance of payments. The program may involve temporary control of imports, so that the most important reconstruction projects will have priority. It must be adjusted to China's capacity to pay for imports out of available assets and credits. The encouragement of export trade and of private foreign investment will play a prominent part in the program as a whole. The government should also do everything possible to help rehabilitate the economy of overseas Chinese, whose remittances before the war contributed substantially to balance China's international payments.

(7) Painstaking effort should be exerted to accumulate the foreign exchange reserve which is vital to the successful operation of the new monetary system. In a free exchange market, reserves should be sufficient to tide over seasonal demands, capital movements and such special needs as debt payment; and reserves must also be sufficient to meet the emergencies of periods in which the balance of payments is unfavorable or in which the currency is under attack. Hence, a reserve should be looked upon as a "regulator fund" which can absorb a drain of exchange and give time for remedial measures to be taken. Even when the free exchange market is closed, which action China was compelled to take by the exigencies of the war in March 1938 and to a greater extent in July 1941, an adequate reserve is still essential for the maintenance of confidence in a nation's financial institutions. This is particularly true in a country like China, where effective price control is difficult to enforce, and where greater dependence must be placed upon the existence of a reserve adequate to hold in check the velocity of circulation.

Furthermore, as indicated by her support of the Bretton Woods plans for monetary stabilization, China regards exchange control as a temporary necessity. Owing to specially difficult circumstances, resulting from the occupation and devastation of vast sections of her territory by the enemy, she will have to take advantage of the provisions for a transitional period which are written into the Bretton Woods plan, and continue exchange control for a time after the war. But it is hoped, as the Bretton Woods plan contemplates, that at the proper time such controls will be lifted and a free exchange market reëstablished. It is essential that China should maintain an adequate reserve in order to facilitate such a transition from exchange control to free exchange which will mark a long step forward in strengthening the fapi and developing China's international trade.

(8) China should continue the policy of wholehearted coöperation for the setting up of international monetary and financial agencies which she pursued at the Bretton Woods Conference. China realizes that the International Monetary Fund and the International Bank for Reconstruction and Development will contribute very materially to promote international trade and facilitate international investment for all countries concerned. Monetary problems have become more and more a matter of international concern, and therefore their satisfactory solution can best be achieved by international coöperation, in which China is willing and anxious to play her part.

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  • H. H. KUNG, Vice-President of the Executive Yuan, National Government of China; chief of the Chinese Delegation at the Bretton Woods Conference; former Minister of Finance
  • More By H. H. Kung