Oct. 20 (Bloomberg) -- Treasury Secretary Henry Paulson told the International Monetary Fund that its finances are ``unsustainable,'' urging officials to cut costs and narrow their work to ensure stability in global markets.

``The IMF's finances have become unsustainable,'' Paulson said in prepared remarks at the Washington-based lender's annual meeting. While new sources of revenue are needed, ``an equally important part of the solution must be to seriously reduce spending by realigning staff and expenditures to focus on the IMF's core mission,'' he said.

Paulson's call for ``reform'' is a challenge to incoming IMF chief Dominique Strauss-Kahn, the former French finance minister who will replace Managing Director Rodrigo de Rato next month. The U.S. wants the lender to police the world's currency markets to make sure countries such as China aren't gaining an unfair trade advantage, Paulson said.

Representing the IMF's largest shareholder, the U.S. Treasury secretary said ``it is time to roll up our sleeves on the expenditure side.''

``A plan for the swift reform of the fund's expenditure and staffing must be an early priority for the incoming managing director,'' he said.

Diminished Lending

The IMF's influence has diminished since it dispatched record sums from Seoul to Sao Paulo a decade ago to rescue economies after the collapse of their currencies. More developing countries than ever are borrowing from private capital markets or saving their own cash, reducing demand for IMF loans.

The IMF faces a 31 percent drop in principal and interest payments in the next five years. Its lending capacity of $161 billion pales in comparison with currency reserves in developing countries that have grown this year to $3.9 trillion, up from $910 billion in 1997, according to IMF figures.

The fund's loans outstanding this year total $17.7 billion, the least since 1980.

Paulson said the IMF should focus on developed economies and their capital markets, leaving poverty reduction to organizations such as the World Bank. He cautioned ``against the IMF's overreaching on longer-term development issues better suited to the multilateral development banks.''

``We believe a clear division of labor between the IMF and World Bank, in terms of areas of policy focus and respective financing roles, will serve to strengthen the work of both institutions,'' Paulson said.

China Monitoring

The IMF was established in 1945 by United Nations conferees to provide emergency loans and surveillance in times of economic crisis. Funding comes from its 185 member countries.

The U.S. Treasury in September 2005, under then-Secretary John Snow, began prodding the IMF to confront China over the value of its currency, the yuan. The U.S. argues the yuan is held artificially low under Chinese policy.

In today's speech, Paulson said currency surveillance is at the ``very core'' of the IMF's role.

``Discussion of exchange regimes and rates, and the spillover effects of members' economic policies on other members, is the one area over which the fund can claim a unique purview, which it should not sacrifice by failing to meet its own responsibility for surveillance,'' he said.

Paulson and European officials, including U.K. Chancellor of the Exchequer Alistair Darling, have called for the IMF's ownership structure to have more representation from low-income and emerging countries.

`Quota Reform'

Poor nations have seen the number of votes they are allocated decline to 2 percent of the IMF's total, from 11 percent in 1945. The decline has come as emerging economies have gained a greater share of so-called voting ``quotas,'' which are allocated according to the size of each economy.

The IMF agreed at meetings a year ago in Singapore to give more shares to China, South Korea, Mexico and Turkey as a first step in a larger overhaul of the voting structure to be completed by next year.

David McCormick, the U.S. Treasury's undersecretary for international affairs, told reporters today that Strauss-Kahn's appointment is no reason to extend the deadline.

``The timeline, at least in my mind, remains intact,'' McCormick said on a conference call from Washington. ``This is an important issue. There has been some progress. There is a lot more work to do.''

Continued Growth

Speaking to finance ministers gathered from around the world, Paulson sought to reassure officials that a tightening of credit and mortgage markets in the U.S. won't prevent global growth from reaching 5 percent for this year and next.

``Recent stress in financial markets is a reminder to all of us that continued vigilance is required,'' he said, adding that markets are undergoing a ``re-pricing of risk.''

``In some sectors, this reassessment has played out more quickly, liquidity has returned and markets are operating more normally,'' the former chairman of Goldman Sachs Group Inc. said. ``In other sectors that are characterized by more complex securities or that rely more heavily on securitization and ratings, conditions are improving, but adjustment will take longer to play out.''

Paulson, 61, said he doesn't expect the rising cost of credit and market turbulence to sink the U.S. into recession. ``Recent credit market events will impose some penalty on U.S. economic growth, but I expect continued growth,'' he said.

To contact the reporters on this story: Kevin Carmichael in Washington at kcarmichael@bloomberg.net;

Last Updated: October 20, 2007 10:47 EDT