World economy sound but China must move on yuan-G7

WASHINGTON (Reuters) - The world economy is sound, although financial markets may remain ragged for some time, and China must let its currency rise faster to rebalance global growth, finance officials from rich nations said on Friday.

Markets have improved since August, when a credit crisis sparked by foreclosures in the U.S. subprime mortgage market spread worldwide, but lingering strains, high oil prices and the housing market mess will likely drag on growth, Group of Seven officials said in a communique after a meeting here.

"We confront these current challenges against the backdrop of a strong economy -- not just in the U.S., but globally," U.S. Treasury Secretary Henry Paulson said after the meeting.

French Finance Minister Christine Lagarde said she was reassured about the state of the U.S. economy after hearing from Paulson and U.S. Federal Reserve Chairman Ben Bernanke.

The G7 finance ministers and central bankers were eager to calm volatile markets, but even as they met, stock prices tumbled around the globe. Caterpillar Inc (CAT.N), a heavy-equipment maker and bellwether for the U.S. economy, reported disappointing earnings and said there was a 50-50 chance of a U.S. recession next year.

The dollar sank to fresh lows, adding to earlier losses when it became clear the G7 -- the United States, Britain, Canada, France, Germany, Italy and Japan -- would not express concern on the greenback's weakness. Oil prices briefly topped $90 a barrel.

When the finance leaders gathered here six months ago, they said it was "desirable" that exchange rates, especially China's, move so that global trade imbalances can adjust. The concern is that a weak yuan makes Chinese exports more affordable, hurting exporters in the United States and Europe.

Friday's communique took a sharper tone.

"We welcome China's decision to increase the flexibility of its currency, but in view of its rising current account surplus and domestic inflation, we stress its need to allow an accelerated appreciation of its effective exchange rate," the G7 officials said.

China has always taken the position -- repeated on Monday by President Hu Jintao -- that it will move gradually and at its own speed on currency and other economic reforms.

DOLLAR SLUMP

Some European leaders have complained bitterly about the steep rise in the euro, saying it put their exporters at a disadvantage. Canadian Finance Minister Jim Flaherty complained Canada had borne the brunt of the global imbalances as its dollar overtook the U.S. dollar this summer.

Paulson reiterated his often-repeated phrase that a strong dollar is in the United States' interest, but that exchange rates should be set by the market -- which has shown no interest in supporting the greenback as concerns mount over U.S. growth and investors bet on more interest rate cuts.

The G7 are also struggling with the consequences of U.S.-originated credit market turmoil stemming from a crisis in subprime mortgage markets that was exported in the form of widely sold securities based on weak loans.

The communique said financial market conditions required close monitoring, and called on "market participants" to examine shortcomings exposed by the credit crisis.

When credit conditions worsened in early August, central banks responded by injecting hundreds of billions of dollars of cash to unfreeze financial markets. The Fed slashed benchmark U.S. interest rates last month to protect the U.S. economy.

But with the dollar falling and oil soaring, inflation fears have grown, and the G7 members acknowledged the delicate balance between promoting growth and keeping prices in check.

In the communique, they said they had acted "resolutely" to protect the stability of global financial markets, but added that "monetary policy must remain vigilant in maintaining price stability," a nod to inflation concerns.

Axel Weber, who sits on the European Central Bank's Governing Council, told Reuters in an interview that the ECB was ready to act if needed to counter higher inflation risks.

The communique also addressed increasing concerns about state-controlled investment vehicles known as sovereign wealth funds, calling them "important participants in the international financial system" while cautioning that more transparency into their investment practices was needed.

The group asked the International Monetary Fund, World Bank and Organization for Economic Cooperation and Development to examine issues of transparency and accountability as Western countries look for assurance that the funds will base their investment decisions on commercial, not political, interests.

The G7 members will host an outreach dinner later on Friday with countries including China and Saudi Arabia that control large investment funds.

(additional reporting by Yoko Nishikawa, Tamawa Kadoya, Sumeet Desai, Louise Egan, Steven C. Johnson, David Lawder and Paul Eckert in Washington)