Soaring in rationality: Bonds as a partial hedge against hyperinflation

Why do states repay their debts? This paper addresses this question by examining how the Nationalist government partially honored major domestic bonds traded in Shanghai—the Consolidated Bonds—amid hyperinflation in post-World War II China. Three main findings emerge: (1) Bond prices surged exponentially between 1946 and 1948, surpassing traditional valuation benchmarks by tens of thousands of times, as a partial hedge against hyperinflation. (2) Price fluctuations were significantly driven by news indicating that the bonds might be redeemed at multiples of their face values following a prospective currency reform. (3) The Government ultimately responded to public expectations by redeeming the bonds at nominally generous multipliers, which aimed not only to sustain its bond issuance capacity but, more crucially, to preserve a currency system closely tied to its bond creditworthiness at relatively low fiscal cost. These findings suggest that a hybrid of the two principal theories of sovereign debt repayment best explains the experience of China’s Consolidated Bonds.