UPDATE 3-IMF gives ground on yuan exchange rate debate

* Split board doesn't say yuan "substantially" undervalued

* Staff sees yuan undervalued by 5-27 percent

* IMF China chief sees yuan "substantially undervalued"

* Fund suggests higher interest rates, 2011 stimulus exit (Adds details from IMF conference call)

By Alan Wheatley and Lesley Wroughton

BEIJING/WASHINGTON, July 28 (Reuters) - The International Monetary Fund has chosen not to call the yuan "substantially" undervalued, a move that recognizes China's efforts to free up its exchange rate and avoids friction with an increasingly influential shareholder.

The summary of an annual review of China's policies released on Tuesday omitted the contentious word, used by IMF Managing Director Dominique Strauss-Kahn as recently as June, which has long riled Beijing.

The yuan has been a flashpoint in relations between China and old-line industrial powers, some of whom have complained that an undervalued yuan was undercutting their exports.

Several members of the IMF's 24-member executive board believed the Chinese currency was too cheap, the fund said.

But others said a structural reduction in the balance of payments surplus was already unfolding thanks to past steps to boost consumption, while others took issue with an assessment by IMF staff that the yuan was substantially undervalued.

"This does reflect a softening in the board's position about the degree of adjustment that is needed in the Chinese exchange rate regime," said Eswar Prasad, a senior fellow at Washington's Brookings Institution and a former IMF official.

He said this was reflected in statements to the IMF board, which met on Monday, that China had already made a big move towards greater currency flexibility and progress in rebalancing demand.

Beijing dropped the yuan's 23-month-old peg to the dollar and reverted to a managed float on June 19. China's trade surplus has also shrunk considerably as government efforts to pump up the economy have sucked in imports of commodities and capital goods.

"On both counts this conciliatory tone is a little premature, because despite the announcement there hasn't been that much movement of the Chinese currency. Any notion that they have in fact successfully started rebalancing their economy is also quite premature," Prasad said.

STAFF SAYS STILL UNDERVALUED

The yuan has risen 0.7 percent against the dollar since it was unshackled from the U.S. currency.

Prasad said IMF economists reckoned the yuan was still between 5 percent and 27 percent undervalued depending on the methodologies used. A diplomat in Beijing confirmed the range.

"Several Directors agreed that the exchange rate is undervalued. However, a number of others disagreed with the staff's assessment of the level of the exchange rate, noting that it is based on uncertain forecasts of the current account surplus," the IMF said.

IMF mission chief to China, Nigel Chalk, said IMF staff analysis put the yuan as "substantially undervalued" based on IMF projections the current account surplus will rebound over the next five years.

Chalk did not acknowledge the range of undervaluation cited by Prasad and the diplomat in Beijing from the staff paper.

"The staff's view of the currency is that the renminbi remains substantially below the level that is consistent with medium-term fundamentals," he told a conference call.

Chalk said IMF forecasts saw the current account surplus, which has fallen to around 4 percent of gross domestic product, rebounding to about 8 percent of GDP over the next five years.

He said Beijing disagreed with that estimate, contending it will stay at the new, lower level.

People familiar with the board's deliberations said representatives of the Group of Seven rich nations supported the IMF staff's conclusions but did not specifically call the yuan "substantially" undervalued.

Reflecting the discussion, the board's concluding statement omitted the disputed phrase.

China was so angry with the Fund's exchange rate views that it withheld cooperation on the annual review from 2007 to 2009.

Beijing, though, has gradually been gaining clout in the IMF. Last year it bought $50 billion worth of notes to beef up the fund's capital and a deputy governor of China's central bank, Zhu Min, has started work as a special assistant to Strauss-Kahn.

The IMF's choice of words is the second qualified recognition this month of the progress China is making in liberalising its exchange rate.

On July 8, the administration of U.S. President Barack Obama said the yuan remained undervalued but declined to designate China a currency manipulator.

The IMF said the scrapping of the dollar peg would increase the central bank's flexibility to tighten monetary conditions.

A stronger yuan rate would also be good for the rebalancing of the domestic and global economies by shifting China's growth from exports and investment to private consumption, it said.

On other issues, the board supported a gradual phase-out of China's massive fiscal stimulus in 2011, provided the current trajectory for the economy -- the IMF expects continued robust growth with benign inflation -- is maintained.

Directors commended the slower pace of money growth that China is targeting this year but urged it to raise interest rates. (Additional reporting by Aileen Wang; Editing by Jan Dahinten and Andrew Hay)