UPDATE 1-U.S.'s Paulson praises China on currency progress

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By Glenn Somerville

BEIJING, April 2 (Reuters) - China has made substantial progress toward adopting a more flexible currency that will help it cope with inflation pressures from rising food prices, U.S. Treasury Secretary Henry Paulson said on Wednesday.

After a day of top-level talks with Chinese leaders including President Hu Jintao, Paulson said he felt China lacks adequate capital markets to have a fully market-based currency but that remains the ultimate objective.

"I acknowledged to President Hu the very material progress that they've made with their currency because they have a currency that more accurately reflects underlying economic fundamentals," Paulson said, adding that gives China "a very important tool" in its bid to keep food price rises in check.

Paulson is scheduled to deliver a speech on energy issues on Thursday and to hold more meetings with senior officials including Premier Wen Jiabao, who has expressed his worry about the potential global impact of a steep U.S. economic downturn.

Paulson said he told the officials he met on Wednesday that the United States was in "a sharp slowdown," adding "It's a very difficult corner we're in right now."

In a later interview on Bloomberg television, he took issue with an International Monetary Fund report slashing its 2008 U.S. economic growth forecast to 0.5 percent from 1.5 percent previously and saying the U.S. economy was expected to tip into recession.

OVERBLOWN

"That sounds a little overblown to me," Paulson said, though he acknowledged that he told Chinese officials "risks are to the downside" for U.S. economic performance currently.

A key reason for Paulson's visit was to meet newly promoted Vice-Premier Wang Qishan, who is taking charge of the U.S.-China "Strategic Economic Dialogue" (SED) that the Treasury chief was instrumental in launching in 2006.

Paulson said he has known Wang, a former mayor of Beijing, for years and worked with him when he headed Wall Street investment bank Goldman Sachs. Wang endorsed the SED process and said he felt it was not only useful commercially but as a means to keep China-U.S. relations on a smooth track.

The next SED session is scheduled for June in Washington. Paulson indicated he expects another SED meeting at the end of the year, after November's presidential elections, but declined to predict its future after that.

"At the end of the day, the next administration will evaluate the SED," he said. "The Chinese understand that and we understand that."

POOR EXAMPLE

Paulson conceded the current turmoil in U.S. markets, stemming from a subprime mortgage meltdown that triggered a credit crunch and forced Treasury to propose a sweeping overhaul of widely-blamed lax regulations, doesn't set a good example.

"There's no doubt that what is happening in U.S. markets clearly has to give the Chinese pause," Paulson said, adding that it was important to learn from experience and keep persuading China to make needed market reforms.

"They've headed down the path to a market economy and capital markets are a very powerful force for good," Paulson said. "The key is that, as they open up and they're the ones that create the regulatory structure, that the same rules will apply to all financial institutions."

Paulson is an advocate of diplomacy to persuade China to allow U.S. financial firms more access to its markets and to persuade Beijing that it is in its own interest to let the yuan rise more swiftly. Many U.S. lawmakers say Paulson's efforts are not producing results fast enough.

But the Chinese central bank has in fact let the yuan CNY=CFXS climb much more quickly in recent months.

The currency gained 4 percent against the dollar in the first quarter, compared with 6.86 percent in all of 2007, as China used a stronger exchange rate as one of the tools to fight inflation, which is at a near 12-year high of 8.7 percent.

However, Tao Wang, head of Greater China economics with Bank of America in Beijing, said she did not expect this pace to last.

"Once the current inflation pressure abates and weak export numbers become obvious, the yuan/dollar adjustment is expected to slow," she said in a report released on Wednesday.

The U.S. Treasury chief also confirmed that he had expressed the Bush administration's concern about China's handling of protesters in Tibet but refused to say whether he had done so in his meeting with Hu.

(additional reporting by Alan Wheatley)

(Reporting by Glenn Somerville, editing by Gerrard Raven, glenn.somerville@reuters.com; +1-202-898-8377; Reuters Messaging: glenn.somerville.reuters.com@reuters.net))