By Wanfeng Zhou and Tetsushi Kajimoto
NEW YORK/TOKYO (Reuters) - The U.S. financial system is healing, Treasury Secretary Timothy Geithner said on Wednesday, but Japan's economy continued to shrink, putting the onus for recovery on how soon the West can return to growth.
The world's worst recession in six decades might be easing, economists say. But with companies slashing jobs and costs, any recovery remains elusive and the consumer and business confidence needed to drive demand is patchy.
The U.S. financial system was "starting to heal" after a period of severe trauma, thanks to the government's bailout efforts, Geithner told the Senate Banking Committee.
A program for cleansing toxic assets from banks will start operating over the next six weeks, he said.
"We still face a very challenging economic and financial environment, and we need to be careful to preserve substantial resources and flexibility to deal with future contingencies," Geithner said.
World Bank President Robert Zoellick was even more cautious, telling a meeting of regional central bankers in Finland that the global situation was still getting worse but "we are likely to see the rate of decline lessen."
Japan's economy, the world's second largest, contracted 4 percent between January and March as capital spending sank at the fastest pace on record and private consumption fell the most since 1997.
With Japan heavily reliant on exports for growth, economists said a lasting recovery will depend on how soon the global economy recovers and demand in the West grows.
"The export plunge is spreading to domestic demand," said economist Hiroshi Shiraishi at BNP Paribas. "As such, the Japanese economy may return to growth temporarily but it could suffer a contraction again afterwards."
U.S. HOUSING IS KEY
The U.S. economy may not emerge from its slump until the housing market stabilizes, economists say.
A Reuters poll found the U.S. housing market, the source of the global financial crisis, is edging closer to a bottom but the timing of a turnaround is highly uncertain.
The Mortgage Bankers Association said demand by Americans for mortgages to buy a home fell last week but overall applications rose, reflecting more interest in refinancing loans as interest rates drop.
"Purchase transactions in general have been at a very measured pace due to the uncertainty associated with the banking sector and unemployment," David Adamo, chief executive of Luxury Mortgage, in Stamford, Connecticut.
The collapse of Spain's housing sector, coupled with a jobless rate of 17 percent, led to a larger-than-expected contraction in its economy in the first quarter.
Worries about the global recession also continue to put pressure corporate earnings.
Deere <DE.N>, the world's largest maker of agricultural machinery, reported sharply lower quarterly earnings as weaker crop prices weighed on demand for tractors and harvesters. Deere also cut its full-year earnings forecast again.
OIL, STOCKS HIGHER
The European Union and China, one of the world's few growing economies, were meeting in Prague on Wednesday to tackle the global downturn.
"Under the storm of the financial crisis, we all understand better that our cooperation means a lot to us and to the world," said Beijing's ambassador to the EU, Song Zhe.
Officials in China have grown increasingly confident that an 8 percent target growth rate this year can be achieved with the help of Beijing's stimulus package and said extra measures would be taken to maintain the momentum of a recovery.
Economists have said falling inventories of oil and metals and a reduced number of unsold homes indicate the recession may be easing. But the question is whether this reflects a return of real demand or a running down of stocks.
Oil firmed above $61 a barrel after data showed U.S. crude stocks fell a much larger than expected 4.5 million barrels in the week to May 15.
The dollar hit its lowest level in nearly five months against the euro and a basket of major currencies, continuing its slide as investors kept the idea that the worst of the global crisis was over.
World stocks rose for the fourth session in a row, with U.S. markets <.N> trading slightly higher after European and Japanese shares ended with slim gains.
"This is still a green-shoots rally," said Michael Woolfolk, senior currency strategist at Bank of New York Mellon. "It's evident in crude oil above $60, it's evident in stocks and it's to some extent being driven by animal spirits."
Despite the market rally, some investors are looking for real improvement in the world economy.
"Expectations of economic news have adjusted and it may now take continued positive news to keep the market moving higher," Goldman Sachs said in a note.
(Reporting by Reuters correspondents worldwide; Writing by Wanfeng Zhou and Tomasz Janowski; Editing by John O'Callaghan)