The Ambassador in China (Stuart) to the Secretary of State 3

No. 6

Sir: I have the honor to refer to the progress of inflation in China during the past twelve months and to describe in non-technical narrative certain of its financial aspects.

On the first of January, 1948 the Chinese National Currency was quoted on Shanghai’s black market at about 140,000 to US$1.00. From then on its slide was uninterrupted but with accelerated momentum until August 19 when the new currency unit, the Gold Yuan, was introduced. Under the Currency Measure of that date the CNC was converted into GY at the rate of 3,000,000 to 1 GY. The GY itself was established at a parity of 4 GY to US$1.00. The conversion rate into US dollars accordingly was 12,000,000 to 1, the figure which approximated the black market rate on that date in Shanghai. It was, however, somewhat lower than the black market rate then prevailing for US dollars in North China and considerably higher than the going rate in South China.

During the Spring commodity prices had accompanied or slightly preceded the rise of the US dollar in terms of CNC in the black market. Adjustments of the open market rate on which legal exports and resultant dollar earnings depended were infrequent and inadequate. In consequence total declared exports averaged during the first six months of the year approximately US$15,000,000 a month, while inward remittances almost ceased. Import licenses were charily issued, and inbound shipments were further reduced by a flourishing smuggler’s trade via Hong Kong.

[Page 730]

In May, under pressure of the business community, Chinese as well as foreign, a partial “link” system was put in effect known as the “Exchange Surrender Certificate Plan”. Under this scheme the exporter sold his foreign exchange proceeds to the Central Bank, which issued him a certificate which he could sell on the open market to importers who were required to have such a certificate in order to buy their foreign exchange. The theory was reasonable, but its practice was not. The market was manipulated in the sense that a drastic further restriction on issuance of import licenses so reduced the demand for the certificates that they fell to a level little more than half the black market rate for dollars. Moreover the Central Bank itself entered the market from time to time, buying and selling certificates. The result produced the curious economic anomaly whereby exports were controlled in fact by the volume of imports. This unusual situation still further increased the resemblance of the Chinese economy to “Alice in Wonderland”.

By mid-June, exports were at a standstill, substantially the full load of essential imports was expected to be assumed by the ECA4 program then getting under way, and the decline in the value of CNC had reached the point where sheer physical inconvenience entered the conduct of transactions in a circulating medium which required practically a bushel basketful to buy a newspaper.

It was clear that the Government must do something, but their course of action was not unveiled until August 19. In brief, the solution then presented was the conversion of CNC into a new currency, the Gold Yuan, tied to the US dollar in the ratio of 4 to 1 and backed by a reserve, 40 percent of which constituted gold, silver and hard currencies, and 60 percent Government-owned shares in state enterprises. All gold, silver and foreign currency held in China was called in. Deposits abroad were similarly slated for transfer to the Government. Finally, all prices and wages were frozen at the level of August 19.

The principal authorship of this plan has been credibly attributed to Wong Wen-hao, the Prime Minister; Wang Yung-wu, Finance Minister; and Hsu Po-yuan, Vice Minister of Finance. O. K. Yui, Governor of Central Bank, played a slight though less clearcut role of parentage.

The preparation of the plan, particularly the currency reform, was a closely and successfully guarded secret. One vital change is believed to have taken place in the scheme only a few days before its promulgation. The facts appear to be that the Generalissimo’s5 approval of [Page 731]the plan was required, since it involved trusteeing China’s gold stock, amounting to something under three million ounces, over which the Generalissimo himself has long exercised a close and jealous personal control. The original scheme put up to the Generalissimo included the daring feature of making the Gold Yuan internally convertible into gold at a fixed rate. This Nineteenth Century economic solution, while pleasing to the ghosts of classical economists, beyond question would have caused John Maynard Keynes6 to rotate rapidly in his grave. It did, however, have the beauty of audacity and just conceivably might have sufficiently engaged the confidence of the Chinese people for long enough noticeably to extend the breathing spell for the Government which the currency reform was designed to achieve. Apparently the Generalissimo, with more insight into Chinese economic realism than respect for the classical school of economists, struck this feature of the currency reform from the measure presented to him.

It is noteworthy that less than three months later this original feature was to be reintroduced, at a time when the further disintegration of China’s currency and economy was even more apparent. The run that then followed on the Government’s gold stock was at that later point easily predictable. The irony of it, however, was that the people who had faithfully turned in their gold as required after August 19 were afforded the doubtful privilege of re-purchasing it from the Central Bank at ten times the redemption price in Gold Yuan and under circumstances which favored the “Yellow Ox” gangs rather than the original owners.

The August 19th reforms were accompanied by devout declarations of an intent to balance the budget by reducing governmental expenses and increasing taxes. The facts of the situation were apparent to anyone who cared to look. The budget was hopelessly unbalanced and, in all fairness, could not reasonably be expected to attain balance, so long as the civil war continued. However, a new currency, a sense of patriotic fervor which was exploited, and early evidence of a resolution on the part of the Government rigidly to enforce the measures, particularly in Shanghai, combined to give the Government a brief breathing space. It was clear, however, at the outset, to any objective observer, that during that breathing space three separate actions, in the military and political fields rather than fiscal, had to be achieved in order to accomplish any enduring result. The first was some immediate, tangible evidence of a reduction in the Government’s deficit. The second was an important military victory by the Nationalist forces in the field. Third was the execution of an exemplary number of [Page 732]individuals above the rank of colonel. None of these conditions was met, and by the middle of September one could predict with safety that the currency and related economic reform measures were a failure.

Moreover, intelligent and flexible administration of this ambitious economic reform program was required. Coming as the reform did, with a secrecy which prevented advance speculative adjustments, the economy of China was frozen overnight. In so serious an inflationary spiral a host of major and minor maladjustments exist at any given moment. All these were frozen on August 19 into the economic fabric of that part of China which has adopted or absorbed any semblance of a finance-capitalist society. Costs, for example, were out of line with selling prices in some important industries. The wide disparity in price levels between North and South China was another case in point.

Chinese economists and many politicians saw the need for discriminating adjustments. They were not forthcoming on any significant scale, primarily because Gen. Chiang Ching-kuo, the Generalissimo’s son, was placed in charge of enforcement in Shanghai, the financial capital. He attacked enforcement more as a social crusade than as a problem needing economic sophistication if the program was to be given its best hope of success. And he was backed up by his father in every dispute with bankers, business men, economists and even the Cabinet. One month after the introduction of the Gold Yuan, time was running out because no effective, constructive use had been made of the time so expensively purchased.

Nevertheless, the value of the Gold Yuan in the black market had sagged by September 20 only 10 percent. Official prices were still prevailing, but goods were increasingly scarce, as buyers’ sprees, taking advantage of fixed prices, cleaned out the shelves. Other stocks went under ground or into a then cautious black market. Moreover, the full scale of the Communist offensive in Manchuria and in Shantung was unleashed.

The economic head of steam had in the short space of four or five weeks built up to a pressure which promised an early explosion. Semi-terroristic enforcement measures in Shanghai, reminiscent of a modern police state, were losing their effectiveness as the sole prop of the currency.

Within a month the black market was in full swing both in commodities and currencies, and by the middle of October the Gold Yuan had lost 80 percent of its value in terms of the US dollar.

On November 1 the Government recognized and accepted the inevitable. The Premier took personal responsibility for the failure and [Page 733]resigned. Price and wage ceilings were removed. The only exception to the removal of price controls was rice, and the inevitable consequence of this short-sighted action was the failure of rice to move into the cities, with attendant shortages and food riots.

By the end of November the wheel had come full cycle in the monetary field. The ownership of, but not transactions in, gold, silver and foreign currency was once more made legal. Gold and silver were placed on sale for the people. The net result of this fiasco was to legitimize the position of the rich who had never turned in their hoards and to pauperize the fledgling middle class which had faithfully turned in their gold and then were forced to compete with “Yellow Oxen” to buy it back at ten times the price. By this brilliant stroke the Government rid itself of any vestige of support from those who had the most to fear from Communism, being neither rich enough to hope to buy acceptable terms from a new regime nor poor enough to feel that a Communist government could only change their status for the better. The year end witnessed two interesting economic developments. First was the introduction in late November of the Foreign Exchange Clearance Certificate plan. This was really a revival of the discredited surrender certificate plan of May, which had been officially buried on August 19. Secondly, the massive Communist victories of November had a curious but innately logical effect on those individuals who had earlier sought to protect themselves against inflation by hoarding of commodities. Fear that these hoards would be discovered and confiscated by the Communists when they took over led to large scale dumping and conversion of goods held by speculators into Gold Yuan. A companion fear, however, was that the Communists might deliberately penalize holders of American dollars just because they were American. The combination of these two fears produced a temporary plateau in commodity prices and a relative decline in the purchasing power of the US dollar.

The forces at work, however, in the form of steady pumping of Gold Yuan into the circulatory system by the printing press and sober second thought, not only on the basic stability of the US dollar, but also on the dollar needs of the Communists to finance essential imports, soon set the spiral in motion again. All except rice, which responded sensibly to a freed economy by moving into the cities and going down in terms of US dollars in faithful reflection of a bumper crop just harvested.

Converting Gold Yuan into CNC, at the first of the year it required 150,000 CNC to buy one US dollar; by the year’s end it required the equivalent of over 400 million CNC.

Respectfully yours,

For the Ambassador:
Livingston T. Merchant

Counselor of Embassy
  1. Drafted by the Counselor of Embassy (Merchant).
  2. Economic Cooperation Administration.
  3. President Chiang Kai-shek.
  4. British economist, advocate of managed currency.