UPDATE 5-G20 set to dilute big powers' demands on currencies
* Communique won't single out Japan on forex
* Drops G7 demand that economic policy mustn't target FX
* ECB says euro trading at long-term average
* U.S. blocking deficit-reduction pledge - sources
* China opposes line on exchange rate targeting
MOSCOW, Feb 15 (Reuters) - G20 officials will disregard key parts of a currency statement issued this week by the Group of Seven powers, according to a communique drafted for finance leaders meeting in Moscow, and will not single out Japan.
A G20 delegate who has seen the draft - put together by deputy finance ministers for their bosses - said it would also make no direct mention of new debt-cutting targets, something Germany is pressing for but which the United States wanted struck out.
If adopted by G20 finance ministers and central bankers at on Saturday, the wording will confirm that Japan will escape any censure for its expansionary policies which have driven the yen lower and drawn demands for action from some quarters.
The currency market was thrown into turmoil this week after the G7 - the United States, Japan, Germany, Britain, France, Canada and Italy - issued a joint statement stating that domestic economic policies must not be used to target currencies.
Tokyo said that reflected agreement that its aggressive monetary and fiscal policies were appropriate but the show of unity was shattered by off-the-record briefings critical of Japan.
The G20 draft merely sticks to previous G20 language on the need to avoid excessive foreign exchange volatility, the delegate said.
One senior G20 source said any reference to targeting exchange rates was not be acceptable to China, which is now the world's second-largest economy and holds much of its $3.3 trillion in foreign reserves in U.S. Treasury bonds.
Officials lined up to pour cold water on talk of a currency war.
European Central Bank President Mario Draghi said recent sparring over currencies was "inappropriate, fruitless and self-defeating" and U.S. Treasury official Lael Brainard warned against "loose talk".
Draghi also said the euro's exchange rate was in line with long-term averages, a point endorsed by International Monetary Fund chief Christine Lagarde.
"The current talk of currency wars is overblown," she told the G20 ministers and central bankers. "There is no major deviation from fair value of major currencies."
Other policymakers in Moscow said Japan's aggressive fiscal and monetary expansion aimed at raising the inflation rate to 2 percent was to be welcomed if it boosted growth.
"There is no competitive devaluation, there are no currency wars," Russia's finance "sherpa", Deputy Finance Minister Sergei Storchak, told reporters. "What's happening is market reaction to exclusively internal decision making."
Australian Treasurer Wayne Swan indicated support for Japan's monetary policy saying "everybody's got a stake" in its ability to foster growth.
And Indonesia, one of the rising Asia-Pacific economies, said it was also less concerned about the exchange rate of the yen than about Japanese growth.
"If the Japanese increase their domestic demand it will help Indonesia, especially from the export side," said Hartadi Sarwono, deputy central bank governor.
Others have noted that the United States has created new money in a very similar way to the Bank of Japan, although Federal Reserve Chairman Ben Bernanke insisted the U.S. central bank was acting in line with the G7 statement, "using domestic policy tools to advance domestic objectives".
GROWTH VS AUSTERITY
The meeting in Moscow of finance officials from the G20 nations, which account for 90 percent of the world's gross domestic product and two-thirds of its population, also looked set to lay bare differences over the balance between growth and austerity policies.
The draft communique reflected a row brewing between Europe and the United States over extending a promise to reduce budget deficits beyond 2016. A pact struck in Toronto in 2010 will expire this year if leaders fail to agree to extend it at a G20 summit of leaders in St Petersburg in September.
The G20 put together a huge financial backstop to halt a market meltdown in 2009 but has failed to reach those heights since. At successive meetings, Germany has pressed the United States and others to do more to tackle their debts. Washington in turn has urged Berlin to do more to increase demand.
"It's very important to calibrate the pace of fiscal consolidation," Brainard said. "It's ... important to see demand in the euro area and some of that must take place through internal rebalancing."
The draft reaffirms G20 commitments to draw up credible medium-term fiscal plans but will also make allowance for the near-term economic downturns facing some countries, the G20 delegate said.
There will be no direct mention of fiscal targets, in response to U.S. pressure, reflecting its focus on running expansive policies until unemployment comes down.
The euro zone's largest economy, Germany, and the European Central Bank, wanted a new borrowing pledge - in line with their own tough medicine for the currency bloc's ailing periphery.
A European Union position paper set out the dispute in stark terms. It said the United States "was not ready to commit to a ... numerical target".
"The EU considers it essential to agree credible and ambitious targets," said the document, obtained by Reuters.
The yen has fallen by around 20 percent since November. But it hit a two-week high against the euro on Friday on speculation the next Bank of Japan governor may be less inclined to pursue aggressive monetary easing and as markets awaited for the G20 summit to pronounce.
Bank of Japan Governor Masaaki Shirakawa said he would defend Tokyo's bold approach to monetary easing, saying the policies were aimed at stabilising the domestic economy. He also said the bout of yen weakness merely reflected receding risk aversion among investors globally.