What a Stronger Yuan Means for the Global Economy

China announced that it would expand the yuan’s trading band against the dollar to 1.0% in either direction starting today. Previously, the PBOC only allowed USD/CNY to move by 0.5%.

It’s interesting to note that the government made the statement following the release of the disappointing GDP report for Q1 2012. Perhaps the 8.1% reading, which printed below the 8.4% consensus, was a wake-up call to officials that they would need to improve the flexibility of the yuan in order to support the economy amid signs of a slowdown.

A lot of economic gurus were pleased with the move as it would help in meeting market demand as well as in promoting transparency. Heck, even the IMF and the U.S. couldn’t help but gush about China’s initiative!

IMF Chairman Christine Lagarde said that by expanding the band, China is a step closer to steering its economy towards domestic consumption. Meanwhile, a U.S. Treasury official said that China’s decision could help rebalance the global economy as if would help reflect underlying market forces.

Other Western economies will also probably appreciate how China’s decision to let the yuan appreciate more freely could help address global trade imbalances. Recall that larger economies in the West, such as the U.S. and euro zone, have been complaining that China’s undervalued yuan has been giving Chinese exporters an unfair advantage in trade. That’s because a weak yuan makes Chinese exports relatively cheaper overseas, and this gives them an edge against more expensive Western products.

Western economies argue that allowing the yuan to appreciate will level the playing field in terms of global trade, as this would make Chinese products more expensive. At the same time, imports to China will become more affordable for Chinese consumers, eventually boosting demand for Western exports. While this sounds like a win-win situation for both China and the West, the U.S. Treasury believes that China can still do more when it comes to making the yuan more flexible.

For now though, China seems intent to reap the benefits of a stronger yuan on the home court before worrying about its longer-term effect worldwide. Recall that China just printed a weaker than expected GDP for the first quarter of this year, as growth was bogged down by weaknesses on the domestic front. As I noted in an earlier article, taking a closer look at Chinese inflation, trade balance, and PMIs painted quite a grim picture of the Chinese economy.

With a stronger yuan promising to make imports more affordable for Chinese consumers, domestic spending and investment could get the boost it needs to eventually restore Chinese GDP back to its double-digit glory. On top of that, higher demand for foreign products could bring the Western economies back on their feet. Now that sounds like a happily ever after, doesn’t it? Let’s wait and see if all goes well!