From silver to gold; and from sterling to dollar

Modern economists tend to forget the first great global imbalance occurred during the Ming Dynasty, when China ran a huge current-account surplus with the West. Chinese exports of porcelain, silk and spices were paid for by silver. During the Wan Li period, the Ming Dynasty encouraged exports in order to earn money to fight the invading Manchus. The huge drain of silver from the West to China caused domestic deflation in the West, which exported opium to China to restore the trade balance.

The combination of opium, unemployment due to falling exports, corruption and natural disasters, plus the huge outflow of silver from 1809 to 1842 gradually brought down the Qing Dynasty. Mistakes about the currency reform between 1929-1937 changed China's fate.

In 1867, there was an international monetary conference in Paris that pushed for the shift from bimetallism (gold-silver) towards gold as the international standard. This policy was pushed by Britain and France and by 1910, every major country was on gold, except China. When everybody went to the gold standard, the price of silver began to depreciate. This devaluation actually gave China an export advantage, but if she borrowed in sterling or gold, she suffered because her reserves were in devalued silver.

Between 1890 and 1930, China had a current-account surplus in terms of an inflow of silver. World War 1 cut off global trade that stimulated Chinese industrialisation around Shanghai and Manchuria and the Chinese and international banks began to flourish in the finance of trade, but also as traders in silver. This created a credit multiplier problem. When there was an inflow of silver, the banks could lend to finance trade and also real estate, thus expanding money supply. However, when there was outflow of silver, the banks had to contract their credit, thus putting real estate prices and domestic jobs under pressure. In other words, Chinese monetary policy was at the mercy of international forces.

Between 1929 and 1931, when the rest of the world was suffering from the Great Depression, China initially escaped deflation because she was on the silver standard, when everyone else went (wrongly) back to the Gold standard at an over-valued rate. After September 1931, when everyone abandoned the Gold standard , China suffered because silver rose sharply against other currencies. The result was net outflow of silver, a trade deficit and domestic deflation. The outflow of silver meant banks liquidated their loans to finance the outflow. This "deleveraging" of bank credit due to silver outflow exacerbated the crisis, in exactly the same way that the world is suffering from current bank deleveraging.

By sticking to silver, China suffered more than necessary from the Great Depression. International supply and demand of silver was beyond the control of the Chinese government, so domestic economic growth and investment was at the mercy of the international silver price.

After the banking crisis of 1934, there was no alternative for the Nationalist Government but to reform the currency. On November 4, 1935, China abandoned the Silver Standard, created the central bank but did not link the yuan to either the sterling, dollar or yen. More important, China did not introduce exchange controls. This was probably a mistake, because once war with Japan broke out and fiscal expenditures got out of control, currency stability could not be maintained and there was huge inflation that destroyed the credibility of the government.

I use history to draw important lessons from the choice of currency regimes. You can only maintain financial stability when you have political stability, as well as the independent tools to maintain fiscal and monetary discipline (including bank credit discipline) necessary to protect that monetary stability. Small economies that do not have their own credibility can borrow credibility through linking to the currency of their major trading partner. However, large players cannot do this without political economy ramifications. The lesson from the Silver Standard is that you cannot rely on a standard that is beyond your control. Do you think a global currency standard by a global central bank would be better at maintaining your currency stability? Think again.

ANDREW SHENG is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served as adviser and chief economist to Bank Negara, deputy chief executive of the Hong Kong Monetary Authority and chairman of the Hong Kong Securities and Futures Commission