LONDON, Aug 11 (Reuters) - The global currency war entered a new and critical phase on Tuesday as China's surprise devaluation threatened to unleash a wave of competitive devaluations and keep monetary policy around the world looser for longer - perhaps even forcing the U.S. Federal Reserve to delay or slow its expected rate rise cycle.
'Currency wars', a phrase used by Brazil's former finance minister Guido Mantega in 2010 to describe how competing countries explicitly or implicitly weaken their exchange rates to boost exports and gain trade advantage, have intensified in recent years.
As interest rates have fallen to zero and below in many developed economies, money printing has proliferated and exchange rates have become one of the few remaining levers to stimulate business activity and, in some cases, avoid deflation.
The European Central Bank's move to quantitative easing in March, for example, was widely seen as a way for the euro zone to weaken what was seen as an overvalued euro and prevent a deflationary spiral in many of its heavily indebted countries.
The Bank of Japan's latest wave of QE was also designed to weaken the yen.
Against that backdrop, China's tight peg to an appreciating dollar meant the yuan's real trade-weighted exchange rate had climbed more than 10 percent over the past year, even as its economy slowed and exports slumped.
But the near-2 percent devaluation of the yuan on Tuesday suggested Beijing had had enough, and was willing to risk toppling another row of regional dominoes and opening up fresh trade tensions with the United States.
The dollar has risen 20 percent on a trade-weighted basis in just one year. This de facto tightening of monetary policy has eroded the competitiveness of U.S. exports, eaten into economic growth and diminished company profits repatriated from overseas.
"(The yuan devaluation) puts the Fed in a difficult spot. It opens the possibility that the Fed might delay (a rate increase)," said Patrick Chovanec, chief strategist at Silvercrest Asset Management in New York. "On its own, it makes it harder to raise rates."
Over the past decade, the U.S. Congress has pressed Beijing to loosen its dollar-pegged exchange rate to allow the yuan to appreciate, arguing that trillions of dollars of currency market intervention had depressed the yuan artificially and given China an unfair trade advantage on global export markets.
That made sense with China growing 10 percent per annum and attracting hundreds of billions of dollars of global capital every year. But with growth expected to slow to its weakest in 25 years and Beijing dipping into its foreign reserves to offset the biggest outflow of capital in years, a looser exchange rate now means a weaker yuan.
"Treasury now has to choose which is more important," said Chovanec, also Adjunct Professor at Columbia School of International Public Affairs. "Should the renminbi (yuan) float, or should Beijing actively intervene to support it and draw down its reserves?"
The People's Bank of China described its move, which caught markets by surprise, as a "one-off depreciation" of the yuan and billed it as a free-market reform.
The yuan's slide to a three-year low instantly rippled across the world. South Korea's won fell 1.6 percent against the dollar, its biggest fall in 10 months, and South African central bank governor Lesetja Kganyago said his country's exports would be less competitive.
"If China is really moving towards greater alignment with the market, which implies greater yuan weakness, this may be a factor that adds more pressure on China-related currencies," Barclays Asia-based strategists said in a note on Tuesday.
Their counterparts at Morgan Stanley also Asian currencies excluding the yen were likely to slide against the dollar.
Many emerging market currencies, including the Malaysian ringgit, Indonesian rupiah and Brazil's real , had already slumped to their weakest levels against the dollar in over a decade as capital fled their slowing economies.
The big question now for emerging markets, where growth has slowed and capital flight has increased dramatically this year, is whether their officials respond to China's move in kind.
"It was inevitable that China would join the currency war at some point. The key will be the response of other central banks ... There should be further pressure on the currencies of China's trade partners," said Nick Lawson, managing director at Deutsche Bank in London.
Central banks dumped as much as $260 billion of foreign exchange reserves in the second quarter as emerging market central banks tried to mitigate the impact of capital fleeing their own economies.
The decline was the largest drop in global foreign exchange reserves in more than a decade, outstripping the depletion in 2008-09 when central banks frantically tried to manage the fallout from the global financial crisis. (Reporting by Jamie McGeever; Editing by Kevin Liffey)