UPDATE 2-China should let yuan,fuel prices rise-US' Paulson

(Recasts; adds details, comments from Q&A)

By Glenn Somerville

WASHINGTON, June 10 (Reuters) - U.S. Treasury Secretary Henry Paulson on Tuesday urged China to let its yuan rise to control inflation and said it should cut energy price controls to ease fuel and power shortages.

A week before the next round of a so-called strategic economic dialogue with Beijing, Paulson said in a speech it was "critical" for China to adopt a more flexible currency regime if it expects to protect its thriving economy from runaway inflation.

"Exchange rate reform will be critical in meeting China's short- and medium-term challenges," Paulson told the Carnegie Endowment for International Peace. "Despite the progress that China has made, including almost 20 percent (yuan) appreciation against the dollar since July 2005, continued movement and greater flexibility are still needed."

He said there was not a specific target value for China's yuan and acknowledged that the country wasn't yet ready for a fully market-determined currency. But he said the yuan's low value was contributing to global trade and financial imbalances.

Paulson signaled that China's energy policies and soaring global oil prices also would be a topic for discussion when top Chinese officials and Bush administration cabinet members meet on June 17-18 in Annapolis, Maryland.

He said China should let market forces determine the demand-supply balance for energy, saying that U.S. attempts to control oil prices in the 1970s failed badly and led to supply shortages and reduced investment in oil exploration and production.

"China, by setting price controls on fuel, is facing similar consequences today -- as can be seen by persistent gasoline and diesel shortages throughout the country," Paulson said. "The consequences of these policies extend to the power sector, where price caps on electricity and fuel contributed to nationwide power outages during snowstorms this past January and February."

He noted that China, whose thirst for energy is cited as a key factor contributing to higher prices, has made some progress in reducing the amount of energy it uses as a percentage of gross domestic product.

He said China cut energy consumption per unit of GDP output by three percent in 2007, but has a long way to go to reach its goals for a 20 percent reduction for the four years to 2010.

"While I applaud this continued focus and am encouraged by this progress, further results cannot come fast enough," Paulson said.

Paulson repeated his view that the run-up in oil prices was not driven by the weaker dollar or speculators and that the underlying cause was growing global demand and tight supplies that have not increased.

Paulson said five areas were up for discussion in the economic talks: managing macroeconomic cycles, developing human capital, keeping markets open to trade, boosting investment and increasing cooperation on energy and environmental issues.

Though the talks have been criticized by U.S. lawmakers and business groups as ineffective, Paulson insisted they were "more productive than protectionist policies or legislation" and did not close off other remedies through the World Trade Organization if they were needed.

He conceded the U.S. economy also faces "significant headwinds" from rising energy prices and said U.S. energy policy needed to "evolve" to ensure energy security.

Paulson did not elaborate, but the Bush administration has clashed repeatedly with Democratic lawmakers over its wish to explore for oil in parts of Alaska's wildlife preserves. (Reporting by Glenn Somerville and David Lawder; Editing by Andrea Ricci)