After the decision by the People’s Bank of China last week, the Chinese central bank, to devalue their currency, the topic of a currency war has once again surfaced.

The term 'currency war', coined by Brazilian Finance Minister Guido Mantega in 2010, refers to the practice in which central banks intentionally devalue their currencies in order to support their export industries. As foreign demand increases, the intention is that domestic industry and employment will benefit. However, the price increase for imports can harm citizens' purchasing power.

The decision by the People’s Bank of China to set the yuan midpoint against the US dollar 1.85% lower than the previous day’s closing level has sent the USD/CNY to a high not seen in three years. And by lowering the costs of buying its manufactured goods, the central bank is giving a boost to all of the important exports industries – drivers of China’s growth for the past three decades.

A devalued yuan also has ramifications for countries competing in similar industries to China, particularly in North Asia.

As its fifth largest trading partner, the U.S. is particularly sensitive to Chinese currency devaluation. Indeed, David Cay Johnston recently reported on Al Jazeera that in June, China sold $1 billion per day more to the U.S. than it purchased. If the yuan falls by say 10 percent, he says that it will make Chinese goods so much cheaper that the U.S. trade deficit with China could increase by about $66 billion annually. That translates into a likely loss of 190,000 to 640,000 American jobs, according to data from the Economic Policy Institute.

Of course, a devalued yuan also has ramifications for countries competing in similar industries to China, particularly in North Asia. Thus, while the idea of a global currency war may be overblown, there may be regional reactions. Countries such as South Korea, Taiwan and Japan compete against China in a lot of similar markets. And now suddenly they see that they are slightly less competitive. This may lead to a desire to depreciate their currencies.

An Overreaction

However, the inflammatory term ‘currency war’ may simply refer to the legitimate prerogative of a country to competitively devalue its currency to support a struggling export economy. The distinction may also be blurred with prudent monetary policy, such as quantitative easing (QE), which seeks to bolster domestic economies.

In fact, just today, European Central Bank policymaker, Ewald Nowotny, dismissed suggestions that central banks around the world were racing to weaken their currencies to gain an export advantage, according to Reuters.

There is no way of currency wars. I don't see this happening, in any case not in Europe but also don't see this worldwide.

"There is no way of currency wars. I don't see this happening, in any case not in Europe but also don't see this worldwide," he told a panel discussion.

Moreover, it is hard to accuse countries of provoking a currency war when their stated objective is to support the domestic economy – via QE, for example. Indeed, the Bank of Japan maintains that its QE policy is in support of the domestic economy, and that the (competitive) devaluation of the yen is simply a secondary consequence.

Likewise, Mr. Nowotny added that the ECB was committed to its quantitative easing programme of asset purchases to stimulate the euro zone economy. "There is clearly no signal that we may end this programme ahead of the time horizon that we have set," he said.