Hayekian Currency Competition in Manchuria 1918–1932

Can multiple, competing metallic standards lead to stability?

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Last year the Institute of Economic Affairs published the Second Edition of The Experience of Free Banking with additional chapters dedicating to Free Banking periods in Belgium, Chile, Italy, Peru, Northeast China, and Sweden. In this post, I’ll be covering Chapter 13 of the book which details the experience in Northern China, by economist Thomas R. Gottschang.

For those who don’t know, Free Banking is an institutional regime in which there is minimal or no regulation of Banks ability to issue their own notes, no government lender of last resort (LOER, like the Federal Reserve with regulating power), no regulations on opening branches, no capital or reserve requirements, etc. Historically it’s fair to describe these systems as lightly regulated, with varying degrees of scale depending on the case study we are talking about. Theoretically, Free Bankers like to explore how an unregulated banking sector would perform under various circumstances.

The Free Banking experience in Manchuria is a unique one, as it provides context on how a roughly unregulated banking sector performed in Manchuria during a period of major political upheaval and economic change. Aside from multitude of competing money substitutes, there were also 3 metallic standards at this time — gold, silver, and copper.

Manchuria, known to the Chinese as the Three Eastern Provinces, was during this time experiencing a period of decay in the Central government. The Qing Dynasty, which ruled from (1636/1644–1912) was replaced by the Republic of China. However, the new central government was unstable and led to regional fragmentation of governance. This enabled local war lords to seize power where viable.

Zhang Zuolin was one of these war lords, initially a bandit leader who then became Governor of Fengtian Province, today’s Liaoning, in 1916. Zuolin was then able to extend his jurisdiction into neighboring Northeast provinces of Jilin and Heilongjiang. In 1917, Zuolin, being the prominent War Lord in the region, introduces a new currency denominated in weights of silver called the Fengtian Piao. The denominations were 1 yuan (dollar), 5 yuan and 10 yuan, the officials desired to set the value equal to the gold-based Japanese Yen notes to increase public confidence and adoption of the new Fengtian Piao.

The Feng Piao was unique in that it didn’t promise redemption in specie or coin, unlike most currencies in China at the time. Instead, the issuing bank (Official Three Eastern Provinces Bank) aimed to stabilize its value through supply manipulation:

1. To appreciate the Feng Piao, the bank would sell silver for feng piao, reducing supply.
2. To depreciate it, the bank would buy silver with feng piao, increasing supply.

The success of this system hinged on maintaining large, well-publicized silver reserves. All market participants — Chinese and Japanese officials, bankers, merchants, and currency traders — viewed the feng piao’s value as directly tied to these reserves.

Currency brokers priced the feng piao based on its open market value, which in turn depended on public knowledge of the silver reserves. These reserves were closely monitored, particularly by Japanese chambers of commerce.

Fengtian officials made significant efforts to establish and publicize a substantial silver reserve before introducing the currency. This strategy proved successful and the feng piao quickly became the most widely accepted Chinese banknote in the region. From page 228 of the book:

“Even Japanese firms, despite their continued reservations about Chinese currency, inevitably found themselves engaged in substantial amounts of business conducted in feng piao. As of December 1927, well into the currency’s terminal decline, feng piao still made up an estimated 72 per cent of all Chinese banknotes in circulation in the Northeast (McCormack 1977: 194)”

The monetary landscape of early 20th century Northeast China was diverse, reflecting the region’s complex political and economic environment. While the Fengtian Piao introduced by Zhang Zuolin became a dominant currency, it coexisted with a variety of other metallic standards and money substitutes.

Paper currency in the region was issued by both official and private Chinese banks. The most common were “yang piao” or “foreign notes,” based on modern silver coinage. In rural areas, “guan tie” or “paper tiao” notes, based on strings of traditional copper cash, were widely used. Farmers preferred these for smaller transactions. Some merchants and traditional Chinese banks also issued notes based on subsidiary silver coinage, called “xiao yang qian” or “small foreign coins.”

Interestingly, while there was no central bank to enforce regulations, banks throughout China adhered to a national standard for the silver dollar. This standard was effectively maintained by private bankers’ associations, demonstrating the power of market-driven cooperation in a free banking environment.

The Northeast’s monetary system was further rife with competition by the presence of foreign currencies. Russian rubles, introduced through the Russo-Chinese Bank (later Russo-Asiatic Bank), became widely used, particularly along the Chinese Eastern Railway. The Bolshevik revolution came with a period of hyperinflation as demand for the ruble fell. After the Russian Revolution, the newly created Soviet Far Eastern Bank (Dalbank), issued new gold-based ruble notes, though these never regained the market share of their pre-revolution counterparts.

Japanese currency also played a major role. The Yokohama Specie Bank issued silver-based yen notes, while the Bank of Chosen (Korea) introduced gold-based yen notes. By 1917, the Bank of Chosen became the sole issuer of gold-based yen notes in Japanese-controlled territories.

Chinese modern-style banks were also active in the region. Each province had its official bank: the Three Eastern Provinces Bank for Fengtian, the Jilin Provincial Government Bank, and the Heilongjiang Provincial Government Bank. These banks provided a range of services, including issuing notes to address currency shortages. Initially, many of these notes were “guan tie,” but as commerce expanded, they also issued silver-based notes of the official Chinese dollar (yuan).

Zuolin’s aspirations for national leadership led to costly conflicts, which put pressure on the currency’s stability.

In 1922, Zhang’s defeat in the First Fengtian-Zhihli War led to increased demands for funding from the Three Eastern Provinces Bank. The number of feng piao notes in circulation doubled from 30 million in 1921 to 60 million in 1924. This expansion, coupled with waning public confidence, caused the feng piao to weaken against the Japanese yen. The feng piao stabilized between 1922 and 1924, despite ongoing military expenditures. This stability was attributed to economic reforms implemented by Zhang’s civilian officials, including railway development and expansion of commerce and industry. These measures increased government revenues, allowing the province to retire outstanding debts and even record budget surpluses.

However, the feng piao’s failure to return to parity with the gold-backed yen was largely due to international silver market fluctuations. The sharp drop in silver prices in 1920, which then remained low for several years, appears to have been the primary factor in the feng piao’s lower but stable exchange rate against the yen from 1921 to 1924.

The currency’s stability was short-lived. Following the Second Fengtian-Zhihli War in 1925, Zhang’s demands for military funding skyrocketed. The number of notes issued more than doubled in a single year, followed by further massive issuances unsupported by additional silver backing. By this point, the link between the currency and its silver reserve base had been severed, and the feng piao had essentially become a fiat currency.

Zhang Zuolin’s assassination in June 1928 marked the beginning of the end for the feng piao. By then, its exchange rate had plummeted to 2,510 feng piao for 100 gold yen. The currency’s decline continued even after Zhang’s death, reaching 10,036 feng piao to 100 yen in 1930.

At the end of the chapter Gottschang (the author) mentions a key aspect of the Chinese system that allowed for efficient coordination of the various metallic standards and substitutes: the currency exchange market.

This market was not a new phenomenon; currency exchange had long been an essential business in China due to the variety of traditional metallic currency bases and local standards.

In the Northeast, the currency exchange market was particularly crucial. Notes issued by official provincial banks often traded at a discount in other provinces, and businesses had to navigate transactions involving Japanese and Russian currencies alongside domestic ones. The Russian administrators of the Chinese Eastern Railway provided a vivid example of this complexity in Heilongjiang Province:

Grain merchants purchasing the annual soybean and wheat crops had to pay farmers in copper cash, guan tie notes (based on strings of copper cash), or small-denomination silver-backed notes (xiao yang piao). They would then sell the produce to warehouses in Vladivostok (Russian port) or Dalian (Chinese port), receiving payment in gold-backed rubles, gold- or silver-backed yen, or silver-backed feng piao.

This intricate web of currencies led to the proliferation of specialized currency exchange businesses. It can be seen as an important element for financial coordination and cooperation through market forces, a common feature that’s been noted when studying other Free Banking systems.

The currency exchange markets served several important functions:

1. They adjusted for the varying levels of responsibility among provincial banking officials in charge of currency issues.
2. They facilitated normal business operations amidst currency diversity.
3. They mediated the effects of metallic price shocks, particularly during and after World War I.

A prime example of the market’s adaptability was its response to the collapse of the Russian ruble following the 1917 Bolshevik revolution as previously mentioned. This event caused major economic difficulties in Heilongjiang Province, where the ruble had been widely used. However, the currency exchange markets quickly facilitated the ruble’s replacement with increased use of the yen, silver notes (da yang piao) issued by the Heilongjiang and Jilin provincial banks, and the new feng piao.

Gottschang mentions that this case study of Free Banking sheds light on two different aspects of Free Banking that has been explored in case studies and theory elsewhere (emphasis is mine):

first, that in an environment dominated by market pressures, competing banks can bring about relative monetary stability; second, that when governmental, non-market priorities take control of currency issue, the result is currency collapse. In short, the experience of Northeast China in the early twentieth century demonstrates both the ability of market competition to achieve monetary stability and the potentially catastrophic consequences of abandoning a market-based monetary system.

IMO, even though this case study takes place over a shorter timespan compared to the likes of Scotland or Canada under Free Banking, the Manchurian free banking experience provides a real-world example of several key theoretical concepts in free banking literature. The competition between various currencies, including the feng piao, silver-backed notes, and foreign currencies, demonstrates the principle of competitive note issue in action. We see how market forces naturally led to the dominance of more stable and trusted currencies, with the feng piao initially gaining widespread acceptance due to its perceived stability and backing. The role of currency exchange markets in facilitating trade and adjusting to economic shocks aligns with the theory of Free Banking and the incentives to supply efficient intermediation between channels of commerce even when utilizing multiple currencies (Selgin 1988: 25–30). Only when Zhang Zuolin decided the pressure Three Eastern Provinces Bank to finance his war campaigns to achieve national power, did the credibility of the regime falter, as well as changes in the international price of silver.

The devalued feng piao as well as other currencies like the gold-based yen continued circulating in the Northeast until 1932, when Imperial Japan established the client state of Manchukuo. Manchukuo created a central bank, introduced a new currency (the Manchukuo yuan), and worked extensively to eliminate other currencies in the region, bringing an end to the era of competitive currencies and note-issuing Banks in Manchuria.

The Manchurian case also offers a few lessons for modern monetary policy debates. It illustrates both the potential benefits of a decentralized, market-driven monetary system and the risks of government interference. The initial success of the feng piao under market discipline, followed by its collapse due to excessive government-driven expansion, provides a relevant example of the importance of maintaining market-based constraints on money creation.

In today’s context of ongoing debates about central bank policies, cryptocurrency, and alternative monetary systems, the Manchurian experience provides evidence that the absence of a central regulatory authority allows for currency competition and market-emergent stabilization mechanisms which can lead to a more adaptable monetary system. It also underscores the need for institutional safeguards against political interference and discretion in money creation.

Gottschang, T. R. (2023). Free Banking in Early Twentieth-Century Northeast China. In K. Dowd (Ed.), The Experience of Free Banking (2nd ed., pp. 218–234). Institute of Economic Affairs.

Ma, D. and Zhao, L. (2020), A silver transformation: Chinese monetary integration in times of political disintegration, 1898–1933. The Economic History Review, 73: 513–539. https://doi.org/10.1111/ehr.12939

Selgin, G.A. (1988). The Theory of Free Banking: Money Supply Under Competitive Note Issue.