By Lucy Hornby
BEIJING (Reuters) - China's economy is set for a soft landing even as global headwinds increase, the International Monetary Fund said in a report on Wednesday that urged further reform and currency appreciation to rebalance growth and reduce risks.
The report said economic reforms so far had substantially reduced external imbalances, but at the cost of significant domestic imbalances fueled by its investment-driven growth model.
In a key change, the IMF said China's yuan was now only "moderately undervalued", a softening of previous language, in an annual review warning of risks to growth if investment were to slow sharply or if there was a sudden rise in non-performing loans. But it stressed Beijing's ability to handle potential shocks.
"Policies should continue to be geared toward achieving this year's growth targets. In the event of a worsening of the external outlook, China has ample room to respond forcefully, using fiscal policy as the main line of defense and with emphasis on measures that support China's medium-term reform objectives," the IMF report said.
The IMF's new language on the currency reflects a growing international consensus that the Chinese yuan is closing in on its fair value after about a decade at an artificially weak level, potentially reducing it as a political or international trade issue.
"The renminbi is assessed to be moderately undervalued, reflecting a reassessment of the underlying current account, slower international reserves accumulation, and past real effective exchange rate appreciation," the report said.
The IMF lowered its medium-term forecast for the current account surplus to between 4 percent and 4.5 percent of GDP.
The IMF's view is that the exchange rate still has a "non-trivial" way to appreciate, Markus Rodlauer, the deputy director of the IMF's Asia-Pacific department, told reporters on Wednesday. He did not give an exact value.
Last year's report said the yuan was "substantially undervalued" against the dollar by between 3 percent and 23 percent, depending on the methodology used.
Chinese contributors to the report rejected sharply the idea that the yuan is not yet fairly valued.
"This assessment, in my authorities' view, is not consistent with the reality," IMF executive director Tao Zhang said in the Chinese authorities' official response, included in the report.
"The sharp decline in the current account surplus and the recent two-way movements in the renminbi suggest that the currency is roughly in equilibrium."
The new forecast for the current account surplus relative to GDP is roughly consistent with what economists consider to be a fairly-valued currency, as well as in line with levels that U.S. Treasury Secretary Timothy Geithner has previously said would help keep the global economy well-balanced.
China's big trade and current account surpluses of past years had fuelled trade tensions with other countries, particularly the United States.
The IMF report warned of a number of risks to the economy, specifically the question of whether banks or local governments would bear the burden of non-performing loans -- many stemming from China's 2008 stimulus package -- if the economy were to slow sharply.
Other recommended reforms included better pricing signals following on China's moves to give banks more flexibility in setting interest rates, more financial investment options to avert another speculative leap into real estate, and tax changes to support a shift from investment-led to consumer-led growth.
"The exchange rate issue is just one part of a package of reforms needed to rebalance the economy," Rodlauer said.
Without those reforms, "it will be very likely that the current account surplus will go up again, not to where it was before but more than it was now," he added.
"Gradual appreciation will be necessary in upcoming years."
The mid-point against which the Chinese yuan may trade was set at 6.3429 against the dollar on Wednesday, its weakest point since December 2011. The yuan has fluctuated against the dollar this year, reversing many years of steady, one-way appreciation.
China doubled the permitted trading band for the yuan in April, saying the currency could rise or fall 1 percent from the mid point.
The IMF, which last week cut its forecast for China's 2012 growth to 8 percent from its April assessment of 8.25 percent, reiterated that the biggest external risk the country faced was a worsening of the euro zone debt crisis.
The IMF's view is above government's target of 7.5 percent and in line with the consensus forecast in the latest Reuters poll.
A reminder of risks to growth came from China's industry ministry which said in an unrelated statement on Wednesday that downward pressure was still being felt by firms from customers at home and abroad, despite signs that nine months of pro-growth policy action from Beijing was gaining traction.
Beijing has followed a program of policy "fine-tuning" since the autumn of 2011, cutting interest rates, easing rules on bank lending, fast-tracking fiscal spending and cutting taxes and red tape for business.
"We can see relatively clear signs from the industry sector that the economy is stabilizing," Zhu Hongren, the ministry's chief engineer told a scheduled news conference.
"But we still need to bear in mind that the foundation of stability in the industry sector is fragile and the downward pressure is still with us," Zhu said.
(Additional reporting By Lesley Wroughton in Washington; Editing by Neil Fullick)