The issues surrounding foreign exchange rates are making a lot of headlines these days. Above all, the idea being widely shared is that foreign exchange rates are bound up with trade balances. However, the repercussions that these issues are supposed to have incurred may largely have been played up.

The exchange rate of the yuan against the US dollar has always been at the forefront of this discussion. However, since the yuan has been pegged to a basket of currencies since 2005, we should look beyond the yuan-US dollar exchange rate and take into consideration the real effective exchange rate. The reason for this is that we are not only trading with the US. The US accounted for 20 percent of China's total exports in 2009 but only 7.7 percent of its total imports.

The real effective exchange rate is the weighted average of a country's currency relative to a basket of other major currencies adjusted for the effects of inflation. It determines an individual country's currency value relative to other major currencies. In other words, it tells an individual consumer how much he or she has to pay for an imported good.

Besides, labor costs in China have picked up a lot recently, and therefore our eyes should not only be fixed on the nominal exchange rate. If we use the rise in labor costs as the de facto inflation index - instead of the CPI - to compute the real effective exchange rate, the yuan has appreciated 50 percent already since 2005.

Some may argue that because the US dollar is used for international trade settlement, any movement of the yuan against the US dollar should on all accounts be a cause for concern.

However, it turns out that whatever currency is used for settlement is simply irrelevant to our export value. What really counts is the purchasing power of the currencies of our trading partners, namely how much their currencies are valued against the yuan.

Contrary to what most people believe, too high a trade surplus is in fact harmful to economic development. We do not trade for the sake of exports. We trade in exchange for the goods and services we need. The foreign currency reserves we accumulate through our exports are of little use to us because they cannot be used to buy goods or make investments at home.

Therefore, the common perception that China makes a loss in their foreign reserves when the yuan appreciates is simply wrong. Foreign currency reserves can only be used to buy goods of the country we export to. In fact, the reason for China's exports to the US is the exchange of goods and services. As long as the "IOU" that China owns buys the same amount of US goods and services - which is independent of the yuan-dollar exchange rate - the purchasing power of the foreign reserves, and hence the "wealth" of China, remains the same.

Take a look at it another way as the trade surplus also means capital outflow. With more than 100 million people living below the UN poverty line, China is not a rich country. This kind of high savings, high capital outflow growth strategy is not the most beneficial to China. But the kind of appreciation caused by productivity improvement is not necessarily bad for us. After all, we could make more money, in the sense of buying more US goods and services than before, while doing less work.

To achieve a trade balance, there are two ways of doing so - either cut savings or increase domestic investment. China has invested a lot in the past few years in the construction of infrastructure, and more focus should now be put on other types of investment. For the long term, human capital investment, such as providing universal education, healthcare, adequate pensions and good nutrition for children to all families, including the ones living below the poverty line should take priority. Only then can savings be reduced, stimulating consumption while boosting long-term productivity growth.

The author, a former investment banker, is currently the associate director of MBA programs at the Chinese University of Hong Kong. The opinions expressed here are entirely his own.

(HK Edition 12/02/2010 page2)