BEIJING (Reuters) -- U.S. Treasury Secretary Henry Paulson urged China on Thursday to work towards a freely floating currency, only to be told that America fails to understand how Beijing is making headway on economic reform.

Speaking at the start of two days of high-powered talks aimed at easing trade and currency irritations, Paulson wasted no time in telling China that Washington wanted market forces to set the rate of the yuan in order to help avert a protectionist backlash.

"We will consider ways to achieve balanced growth, and talk about the importance of currency flexibility in the short term and a path to freely tradeable currency in the medium term," he said at the formal start of the talks.

Vice-Premier Wu Yi responded that China felt "some American friends are not only having limited knowledge of, but harboring much misunderstanding about, the reality in China."

"This is not conducive to the sound development of our bilateral relations," Wu, China's most powerful woman, said.

But Wu, calling the talks of critical importance, said China was aiming for a rough balance in its trade and pledged further reforms so the exchange rate, interest rates and a host of other prices were driven by supply and demand.

Paulson later said Wu was right that the United States needed a better understanding of China's policy priorities.

"But having said that, there's certain things that there's plenty of understanding on, and they have just got to move quicker," the Treasury chief told a small group of reporters at the end of a day he described as "productive and informative."

"They're so big and such an economic powerhouse that the rest of the world is going to be impatient, particularly the U.S., and so they need to accelerate the reform," Paulson added.

Tangible results

The talks are billed as a "strategic economic dialogue" to emphasize the long-term solutions that will be needed to reduce the trade and savings imbalances that mark the two economies.

And Paulson, who has said his aim is to lay the basis for a relationship that will have consequences for the United States for generations, told reporters that it was not reasonable to expect concrete results from just two days of talks.

But the Treasury secretary told Wu that, with resistance to globalization on the rise, he needed to counter skepticism about the usefulness of the dialogue.

"Therefore, it is incumbent upon us, not only to have frank and energetic discussions, but also to produce tangible results on the most important issues facing our two nations," he said.

The People's Daily, mouthpiece of the ruling Communist Party, suggested political pressure was forcing Paulson to modify his previously "enlightened attitude" to China's reforms.

"Recently, perhaps due to excessive pressure from U.S. domestic interest groups, his tone has hardened," the paper said in its overseas edition.

Grumbling over the trade deficit with China was a theme throughout last month's U.S. Congressional elections that cost President Bush's Republican party control of both the House of Representatives and the Senate.

China critic Sen. Charles Schumer, a New York Democrat, said on Wednesday that Paulson must demonstrate that he can produce results from the talks with China if he intends to ward off potential renewed trade action against the Asian export giant.

Washington reported a record $24.4 billion trade deficit with China in October, 40 percent of its total deficit.

"The new Congress will be eager to see the results of the trip, because just talking will not suffice any longer," warned Schumer, who has indicated he might try to revive proposals for punitive tariffs on Chinese imports.

Flexibility, please

In what might have been a token of goodwill, China let the yuan rise on Thursday to its highest level since it revalued the currency by 2.1 percent in July 2005 and set it free to float within tightly managed bands.

The yuan reached 7.8180 per dollar before closing at 7.8185, marking a gain of 3.7 percent since the revaluation last year.

But Schumer, other lawmakers and some businessmen say the yuan remains substantially undervalued, given China's balance of payments surplus of some 10 percent of national output.

Paulson, a former chairman of investment bank Goldman Sachs, said a market-driven currency based upon economic fundamentals would help China achieve balanced growth and give it more leeway in setting monetary policy.

"You understand our strong view that in the meantime more currency flexibility is necessary," added Paulson, who is accompanied by six other cabinet officers and U.S. Federal Reserve Chairman Ben Bernanke.