A street in downtown Shanghai during the Great Depression of the 1930s

It was the best of times; it was the worst of times.

The opening line of A Tale of Two Cities could be an apt description of the circumstances surrounding China's currency reform in 1935.

The 1930s are remembered as the era of the Great Depression. Recession struck almost every country with trading relations with China. The decline of China's silk and tea exports, however, were only a fraction of the country's woes.

That decade was one of the most flooded in China's history. Major rivers overflowed almost every year between 1930 and 1935, killing as many as 4 million people. The 1931 Central China Floods was ranked by some the deadliest natural disaster in human history. One quarter of the nation's farms flooded and more than 52 million people were affected. The domestic market for China's nascent industries shrank.

The phantom of war was lurking.

Japan invaded China's three Northeastern provinces (Heilongjiang, Jilin and Liaoning) in the September 18 Incident (also known as "Mukden Incident") in 1931. The January 28 Incident broke out in Shanghai the following year, resulting in the demilitarization of the city.

Disruption

A change to China's currency system was long overdue.

Till the early 1930s, money in China came in so many different shapes and forms that it was easily the most confusing in the world. Four kinds of money - sycee, silver dollars, paper money and copper coins - were in circulation and served different purposes.

Asst. Prof. Lee Pui-tak. Edmond Tang

To list their provenance would be a nightmare: Mexican coins were brought in by foreign traders, silver dollars were minted by Qing Dynasty customs, bank notes were issued by both foreign and Chinese banks in Shanghai... In The Modern History of China's Currency, researcher Wei Jianyou lists more than 100 kinds of sycee alone.

Money preferred in different areas or different trades varied, creating hundreds of mini-currency zones. For goods to move from one area to another, or from wholesalers to retailers, money had to be exchanged through a complicated process, which impeded the flow of merchandise, increased trading costs and created extra risks from exchange rate fluctuations.

Then the dilapidated currency system suffered another blow: the silver drain.

Before the Great Depression broke out in 1929, silver had been flowing into China. The silver price was on a steady decline in the global market since the establishment of the Gold Standard. Silver fetched a higher price in China.

The trend was reversed after 1931 when most Western countries abolished the Gold Standard and the price of silver shot up. It became more profitable to sell silver overseas than invest on production in China. Silver flew out of the country. During the peak year of 1934, when the US announced the Silver Purchase Act, 257 million silver dollars were shipped overseas.

This caused a ruinous credit crunch in China's hinterland. Silver stopped coming to the rural areas during the harvest season, forcing farmers to take up loans for the following year's production and eventually go bankrupt. Factories had to close down, because banks were no longer willing to lend.

From silver to paper

It was against this economic background that the Kuomintang government in Nanjing launched the 1935 currency reform. On November 3, it declared fabi - the paper money issued by government banks - would become the legal tender and all silver dollars would be nationalized.

To persuade people to hand in precious metal coins for paper currency with no intrinsic value was no easy task, especially when a government was on the verge of bankruptcy.

Committing to exchange fabi for the two hard currencies at fixed rates, the Nationalist Government succeeded in establishing credit for the new currency.

The currency reform was, in many ways, a success. The money supply resumed. The deflation was under control. Boosted by a bumper harvest in most provinces, China's agricultural output leaped 45 percent year-on-year in 1936 while industrial output increased 11 percent.

From the preparatory work started in 1929, the currency reform, a crucial conversion in China's currency from metal to paper money, was completed in the space of seven years.

"It was a great example of how opportunity is hidden in crisis," said economic historian Lee Pui-tak, a research officer and honorary assistant professor at the University of Hong Kong's Centre of Asian Studies.

Without the Great Depression, the silver drain or Japan's invasion of the three northeastern provinces, the reform would not have gained the support from the US and Britain or from the commercial banking sector, he said.

Risks and flaws

At the same time, the reform was also an extremely risky move.

Japan, which had failed to gain any advantage in the new currency regime, had opposed the reform from the beginning and launched a currency war afterward. Collecting fabi and converting them into foreign currencies, Japan attempted to exhaust the Nationalist Government's foreign reserve and break down the convertibility of fabi. It would have succeeded if the US and Britain had not extended massive loans for China to stabilize fabi.

Some historians have even linked the breakout of full scale war between China and Japan to the currency reform. Hawkish faction in Japan had used the threat of "the ABC alliance (America, Britain and China)" as an excuse for its aggressive policy.

"The currency reform is doubtlessly a catalyst for the full-scale war," Lee said.

Seeing its stimulating effect on China's economy, Japan's military argued China must be subjugated before it grew stronger. The prevailing view was "it's now or never", he said.

And the reform had a fatal flaw: its reliance on the US and Britain.

"It's all well when the two countries said yes. What happened when they said no?" he asked.

As it turned out, fabi collapsed in the later years of the Chinese civil war (1945-49) after the US withdrew its support.

Challenge ahead

Today's China faces a new currency reform. To fully integrate with the world economy, China has to make renminbi fully convertible sooner or later.

There are many voices urging for faster pace in the liberalization. But, again, China's situation is special. Though China holds staggering foreign reserves of $1,950 billion, it would not be enough to cover 14,000 billion yuan ($2,083 billion) in personal savings. This is not considering the 10,000 billion yuan ($1,464 billion) bank deposits held by enterprises.

"If you compare these figures, now is definitely not the right time for full-convertibility of the renminbi," Lee said.

Like China's currency reform in the 1930s, there are enormous problems and challenges both internally and externally. The Great Depression and the Japanese invasion scared everyone in the 1930s. But China used them to push through the currency reform.

"We can take advantage of the current economic crisis, too," he said.

The 1 yuan and 10 yuan fabi notes

(HK Edition 04/18/2009 page3)