A view of old Shanghai bund in the 1930s China Daily

It was the first half of 1930s. As the gloom of the Great Depression shrouded the West, Shanghai was basking in the exuberance of an apparent boom. Real estate prices were on fire. Bond and commodity exchanges were thronged with speculators. The shopping area around Nanjing Road was growing despite the short life spans of some tenants. And extravagantly-decorated dancing halls never seemed to lack patrons sporting latest European fashion styles.

Shanghai's heady signs of prosperity were especially eerie amid the poverty and misery of the country.

War and floods

The 1930s witnessed one of the most flood-filled periods of China's recent history. Deluges were recorded in 1930, 1931, 1932, 1933, 1935 and 1939. Most devastating were the 1931 Central China Floods, ranked by some as the deadliest natural disaster in human history. Inundation from major rivers including Yellow River, Yangtze River and Huai River drowned some 400,000 people - even if some estimates ran as high as 4 million. Almost a quarter of China's population was affected and 28 percent of the country's farms were destroyed.

For China's burgeoning industries, "a market of 100 million silver dollars disappeared," said economic historian Lee Pui-tak, a Research Officer and Honorary Assistant Professor of the University of Hong Kong's Centre of Asian Studies. The natural disasters hit the Chinese economy more severely than the Great Depression, which started in America in October 1929.

A bigger threat came from imperialistic Japan. Even though the Kuomintang unified the country through a civil war against the northern warlords ruling in Beijing in 1926-27 known as the Northern Expedition, Japan was determined to keep the country divided in its attempt to dominate China. In 1931, the September 18 Incident (also known as "Mukden Incident") broke out and Japan's Kwantung Army occupied three northeastern provinces (Heilongjiang, Jilin and Liaoning).

The 10-yuan note issued by the central government in the 1930s

The three northeastern provinces were a crucial economic zone for China. It's the only region where exports exceeded imports, a feat not achieved even by the textile-exporting lower Yangtze River.

"China had not just lost an economic pillar, but a key consumption market," said Lee Pui-tak.

The full-scale resistance wasn't declared until 1937. But more "incidents" followed, instigated by Japan's military. The most noteworthy was the 1932 Shanghai War.

Also known as the January 28 Incident, the war started with the beating of five Japanese monks in Shanghai. By the end of month, it had escalated into a fierce battle that lasted until March 2. Though the poorly armed Chinese troops were hardly a match for the well-prepared Japanese, both sides suffered severe casualties. The ceasefire was later brokered on the condition of Shanghai demilitarized.

Strangely, the 1932 Shanghai War had no significant impact on Shanghai's vibrant business scene. The war disrupted the financial market but the buzz resumed almost immediately after the ceasefire.

Hot money

Part of the reason was that Shanghai had more than enough hot money to spare, said Lee Pui-tak.

The traditional view of the Great Depression's impact on China centered on diminished exports. But China's crisis had more to do with Japan's invasion, the flooding and the hot money in Shanghai.

"China's economy was semi-closed because China used silver as currency while the rest of the world practiced the Gold Standard," he said.

The unique Silver Standard helped buffer the shock of the global recession, but when the world resumed using silver for currency, the metal flew out of China in the form of hot money.

The problems were exacerbated by political instability after World War I, which stifled long-term investment in the West and sent excess wealth globetrotting to preserve value, said Lee Yu-ping, Associate Research Fellow of Academia Sinica in Taiwan.

The price of silver had been on steady decline in the global market since late 19th Century because of the establishment of the Gold Standard. In China, however, silver fetched a higher price, attracting sellers from around the world.

The influx of silver caused a credit expansion that helped China complete its first wave of industrial development, argued Tomoko Shiroyama in China During the Great Depression: Market, State, and the World Economy, 1929-1937.

However, the trend was reversed after the Great Depression. Western currencies devalued and the price of silver went up and up. As both the domestic and international markets sagged, it became more profitable to sell the silver than investing in production. Silver started to flow out of China through Shanghai in 1929. Outflows peaked in 1934 when the US announced the Silver Purchase Act.

"More than 10 million taels of silver left China every year after 1932. In 1933, for example, the outflow had already reached one third of the world's total supply," said Lee Yu-ping.

Bubbles grew quickly in Shanghai's market as silver poured in. Money, real estate, gold, government bonds all became objects of speculation.

Contrast with the hinterland

China's hinterland, on the other hand, suffered a ruinous credit crunch.

Silver stopped coming to rural areas during harvest seasons, forcing farmers to take up loans to continue operating, loans which eventually bankrupted many of them. In turn, banks stopped lending and factories had to shut down.

"It was a case of congestion in Shanghai, anemia in hinterland," said Lee Pui-tak.

China has undergone a lot of changes since the 1930s. Yet, when comparing the impact of the economic crisis now and then, it's not difficult to find parallels.

In both cases, China's currency - the silver in the Gold Standard era and the not fully convertible Renminbi today - played a decoupling role. In both, foreign investment helped economic development before both crises hit.

But "we must recognize the fact that it can cause great harm, too, as the silver was retained by foreign banks who had been waiting to sell at a most profitable price," said Lee Pui-tak.

One lesson from the 1930s may be that China has to deal with special circumstances and crises may play out in unexpected ways. As a new round of downturn sets in, it may be time for China to adjust both internal and external financial policies and find a balance to open its economy, he said.

(HK Edition 03/14/2009 page4)