Leiden Law Blog

Made in China. Hong merchants, foreign debt and the rise of bank deposit insurance in the U.S.

Made in China. Hong merchants, foreign debt and the rise of bank deposit insurance in the U.S.

The Chinese port city of Canton was in turmoil in 1780. Several of the greatest merchant houses were tottering and had ceased to repay their foreign creditors. The frigate Sea Horse had been dispatched from India to exert pressure, and one desperate creditor even stormed his debtor’s warehouse with loaded pistols to take possession of the premises. Order was only restored when the Chinese government persuaded the remaining merchant houses to assume collective liability for the foreign debts of their failed colleagues. Over the next ten years, they ended up paying nearly 13.9 million dollars in present day money.

Out of this gunboat diplomacy grew the “Canton guaranty system”. The Chinese side of European trade at Canton had been conducted through a guild of licensed merchants, or Hongs, since 1755. They held a monopoly on foreign trade in exchange for security duties: to keep the barbarian Westerners in check and secure the flow of taxes and retributions to the Imperial Court. As a consequence of the Chinese debts crisis of 1780, collective liability for failed guild members was added to their duties.

The guaranty system at Canton ran until 1842, mostly to the benefit of foreign creditors who knew that their loans to Chinese merchants, even if nominally illegal, would always be repaid. Yet from the viewpoint of the Hong guarantors, it was never anything but an unmitigated disaster. Bad debt was rolled on and never restructured; the backing of the guaranty encouraged weaker Hongs to take dangerous risks (moral hazard); and creditors would frequently lend money to weak Hongs against higher interest on the strength of the guaranty (adverse selection). Worse, the guaranty fund, which should have been filled with the proceeds of a tax on trade, was frequently exhausted by government use as a private piggy bank.

The system eventually crumbled under several massive Hong failures, contributing directly to the Opium War of 1842. In the final settlement, obtained yet again by gunboat diplomacy, the merchants were saddled with the obligation to pay roughly 83 million dollars in present day money.

Yet by this time, the guaranty system had crossed the ocean to the U.S., where it had been hailed as an inspiration and a great success. The state of New York was suffering from a banking crisis in 1829. Private banks had been printing more paper currency than they could cover, and public confidence was at a low. The reformer Joshua Forman (1777-1848) believed he could restore confidence by the introduction of a “Safety Plan”. It consisted of mandatory, collective liability between the banks, at first only to insure banknotes but later also for deposits. As Forman expressly said, the propriety of this scheme was inspired by the regulation of the Chinese Hong merchants, making this one of the strangest, and most noteworthy, legal transplants.

Bank deposit insurance spread from New York to the U.S. during the Depression, and from there to the rest of the world in the 1970-2000 period. It has, of course, evolved from its Chinese ancestor. Yet if there is a lesson to be drawn from history, it is that measures intended to fortify the system (protective laws, reserved funds, limited insurance, adequate supervision) are often ignored in times of crisis. To dangerous effect: as history shows, debt collection and violence go hand in hand.

Want to know more? This blog summarizes several points made by Frederic D. Grant jr. in his dissertation, which he defended last week supervised by prof. Leonard Blussé van Oud Alblas (faculty of humanities) and myself.

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