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«Exporting Hyperinflation: The Long Arm of Chiang Kai-shek Richard C. K. Burdekin and Hsin-hui I. H. Whited* Claremont McKenna College and University ...»

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Claremont Colleges

working paper 2001-18

Economics papers by faculty at Claremont Graduate

University, Claremont Institute for Economic Policy

Studies, Claremont McKenna College, Drucker School

of Management, Harvey Mudd College, Lowe Institute,

Pitzer College, Pomona College, and Scripps College.

Exporting Hyperinflation: The Long Arm of Chiang Kai-shek

Richard C. K. Burdekin and Hsin-hui I. H. Whited*

Claremont McKenna College and University of Southern Colorado

June 2001

Abstract As mainland China’s inflationary spiral accelerated in 1947-1949 there was a massive outflow of funds to the island of Taiwan. The exporting of China’s hyperinflation was facilitated by the fixed, overvalued, exchange rate between the mainland Chinese currency and the Taiwanese currency that was adopted in August 1948. Empirical tests offer support for the importance of the 1948 monetary policy reform and suggest a substantial impact of capital inflows and excess money growth in mainland China on inflationary pressures in Taiwan. We find no independent role for Taiwanese money growth in the inflation process.

JEL codes: E31, E65, F42, N15 * The authors thank Tom Willett, Marc Weidenmier, Kerry Odell and Eric Helland for helpful comments and are grateful to Munir Quddus for kindly furnishing the data employed in Quddus, Liu and Butler (1989).

Contact: Richard C. K. Burdekin, Department of Economics, Claremont McKenna College, 500 E. Ninth Street, Claremont, California 91711. ‘Phone (909) 607-2884; Fax (909) 621-8249; Email richard.burdekin@mckenna.edu.

There is a large literature on the international transmission of inflation under fixed exchange rates. In the Bretton Woods era, for example, with the US dollar serving as the reserve currency, the United States was able to export inflation as other member countries absorbed the outflow of funds triggered by excess US money supply growth.1 By May 1971 the persistent outflow had reached overwhelming proportions, prompting other Bretton Woods members to close their foreign exchange markets and end their support of the fixed exchange rate with the US dollar (Schwartz, 1983). But the inflationary effects of the outflow of funds form the United Sates pale against the outflow from mainland China to Taiwan during the twilight of Nationalist rule on the mainland over the 1947-1949 period. This outflow reached mammoth proportions in 1948 following the adoption of a fixed rate of exchange between Taiwan’s currency and the newly-issued gold yuan on the mainland. The rate of exchange was held fixed through the fall of 1948 in spite of rapidly accelerating money growth on the mainland and this facilitated the transmission of mainland China’s hyperinflation to Taiwan as holders of gold yuan took advantage of the increasingly overvalued fixed exchange rate. And, unlike the Breton Woods members, Taiwan had no immediate option of exiting the fixed exchange rate system imposed from mainland China by the Nationalist government. The Taiwanese experience therefore offers a particularly vivid illustration of the international transmission of inflation – in this case an outright hyperinflation – under fixed exchange rates.

The hyperinflation in mainland China was itself fueled by wartime expenditures that continued after World War II in the face of civil war. The conflict between Nationalist forces under Chiang Kai-shek and Communist forces under Mao Tse-tung continued until 1950.

Massive budget deficits and increasing reliance on the printing press are familiar ingredients of hyperinflation and all are clearly evident in the Nationalist Chinese case (see Table 1). But the inter-relationship between inflation in mainland China and inflation in Taiwan, which was returned to Nationalist control by the Japanese on November 1, 1945, is a unique element not mirrored – as far as we are aware – in any other hyperinflation episode. Taiwan’s resources and the Bank of Taiwan’s printing press were used to help finance the Nationalist war effort.

Moreover, the Bank of Taiwan was forced to accept the depreciating Nationalist currency and exchange it for the separate Taiwanese currency at an overvalued rate -- thereby further fueling overall monetary expansion and inflationary pressures on Taiwan. This exporting of hyperinflation to Taiwan leaves the policies of Chiang Kai-shek with the dubious, and quite possibly unique, honor of being responsible not just for one hyperinflation but rather for two.

There is little empirical evidence on how Taiwan’s inflation was affected by events on the mainland. As far as we are aware, the only formal tests on this issue are those of Lin and Wu (1989), who find that mainland inflation (as measured by the inflation rate in Shanghai) Grangercauses Taiwanese inflation over the January 1946-April 1949 period.2 In this paper, we seek to re-examine the importance of the mainland Chinese variables to Taiwan’s inflation and also allow for the effects of the capital inflow from mainland China to Taiwan over the 1947 to 1949 period. Finally, we test for a structural break following the monetary reform in mainland China in August 1948 that is thought to have spurred capital inflows and inflationary pressures in Taiwan.3 The acceleration in Taiwanese prices following this reform is evident in Figure 1, which plots Taiwan and mainland China price movements over the 1947-1949 period (based on wholesale price indices from the cities of Taipei and Shanghai). Our empirical work confirms the importance of the August 1948 reform to Taiwan and suggests that Taiwanese inflation rates are significantly affected by capital inflows and mainland China inflation and money growth rates. Taiwanese money growth is endogenously driven by such external factors and appears to have no independent role in the inflation process.



After the Bank of Taiwan was taken over by the Taiwan Provincial Government in November 1945, the Bank of Taiwan set up a special deposit program to withdraw the old Japanese notes and prohibited the circulation of notes issued after the Japanese surrender. By the beginning of December 1945, the money issued had decreased 20% from the level in October and this deposit program seemed to be effective in reducing the pressure to print money for deficit finance. However, the Bank of Taiwan was now faced by new loan demands from the Chinese Nationalist Government. By May, 1946, the loans debited to the Taiwan Provincial Government equaled 62.8% of the Bank of Taiwan’s total loans. On May 22, 1946, the Bank of Taiwan was authorized by the Nationalist Government to issue a new local currency called the “taipi”, in an amount of 5.3 billion yuan. There were no reserves for the taipi and the circulation of the taipi was limited to Taiwan. In addition, the issuance of taipi was subject to Nationalist government approval. Makinen and Woodward (1989, p. 91) state that, after this point, “the public finance practices of the Taiwanese government paralleled those on the mainland in that a major source of revenue was derived from the inflation tax.” Not only did the Bank of Taiwan face the huge burden of financing the expenses of both new governments (the Taiwanese Provincial and the Nationalist government on the mainland) but also loans to the government were augmented by unsecured loans to state-owned enterprises (Lin and Wu, 1989, pp. 932-933).

The rate of inflation accelerated dramatically during the second half of 1948, reaching 109.9% and 96% in October and November, respectively. This dramatic change was a direct consequence of the August 19, 1948 monetary reform in mainland China that replaced the old “fapi” currency with the “gold yuan” as the official currency on the mainland. Under this reform, private holdings of gold and silver were prohibited and all specie had to be turned into the central bank in exchange for gold yuan notes. Prices and exchange rates were frozen at the August 19 levels, and extreme penalties were adopted against hoarders and black marketeers. In Shanghai, Chiang Kai-shek's eldest son enforced these restrictive measures using the secret police. Also, on August 23, 1948, the US Ambassador to China, John Leighton Stuart, wrote that "the Central Bank and Central Trust are reported to be releasing stocks of commodities in Shanghai and Canton, particularly cotton yarn, and restricting bank credit" (US Department of State, 1949, p.

877). Ambassador Stuart (op. cit.), foresaw, however, that none of these measures could enjoy more than temporary success given that the government budgetary deficit, which is what keeps the printing presses rolling out paper, remains with us, and even given maximum economy where economy is possible, the deficit will of necessity remain unmanageable as long as the war goes on.

The government’s financial and military positions were both perilous at this time. Losses to the Communists had severely disrupted production and transportation and depleted the government's tax revenue.4 Fueled also by rising military spending, the budget deficit rose from 29 thousand billion fapi in 1947 to 425 thousand billion fapi in January-July 1948 (see Table 1).

This deficit was financed primarily by money creation, and Table 1 shows a 1029% increase in the money supply between December 1947 and July 1948. The first seven months of 1948 saw a 45-fold increase in the Shanghai wholesale price index and a 50-fold increase in the black market exchange for the US dollar (US Department of State, 1949, p. 399).

In August 1948, the Minister of Finance announced that the budget deficit "would be reduced from 70 per cent to 30 per cent of government expenditure" (Chang, 1958, p. 80). The maximum allowable issue of gold yuan notes was set at 2 billion yuan. Although October's budget deficit was reduced to 49% of spending, the reliance on deficit spending quickly increased again, reaching 75% of spending in November and 83% of spending in December (Table 1). It was soon obvious that there were little grounds for confidence in the new monetary standard.

While deposits in private banks in Shanghai initially rose after the reform and velocity of circulation of money declined, Chang (1958, p. 274) states that by the end of October the index of the note issue was four and a half times that of August, price and wage ceilings were in the process of disintegration, and it was abundantly clear that inflation could no longer be contained by the expedient of the currency change... In November the value of checks cleared in Shanghai rose to more than three times the note issue, and the velocity of circulation of money jumped nearly six times the October figure... The black-market rate of interest leapt to 120 per cent per month...

Besides simply unloading unwanted gold yuan notes by purchasing goods and services, mainland Chinese sought to transfer funds to South China en transit to Hong Kong.5 But the exchange rate arrangements adopted in August 1948 also gave a special impetus to capital flight to Taiwan. Prior to August 19, the exchange rate system adopted between the fapi and taipi currencies was an adjustable (or managed) exchange rate system. On August 18, 1948, the exchange rate between these two currencies was 1:1635 (one taipi was equal to 1635 fapi). On August 19, 1948, the exchange rate between the gold yuan notes and fapi was set at 1:3,000,000 (one gold yuan note was equal to 3 million fapi). The official exchange rate between the taipi and the gold yuan note thus became 1835:1 (1835 taipi equal to one gold yuan note).

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