* Vale could buy up to a 15 pct stake in Fortescue on market
* Ore blending to start within 6 months, in China
* Fortescue shares touch 16-month high (Adds Fortescue CEO, China steel association comments)
By Stephen Eisenhammer and Sonali Paul
RIO DE JANEIRO/MELBOURNE, March 8 (Reuters) - The world's no.1 and no.4 iron ore miners are in talks that could see Brazil's Vale SA taking a minority stake in Australia-based Fortescue Metals Group and blending their iron ore to win market share in China.
The proposal will help the pair match the quality of iron ore produced by rival Rio Tinto , seen as the benchmark in China, and comes just as beaten-down iron ore prices stage a recovery to eight-month highs.
The two companies have been in talks for around a year, Fortescue said on Tuesday, for what would be the first deal involving the "big four" iron ore miners following a collapse in the price of the steel-making commodity in recent years.
The non-binding memorandum of understanding could see Vale buy between 5 and 15 percent of its Australian rival's shares on market, which up to Monday had been sitting not far off seven-year lows. It would also allow Vale to take stakes in Fortescue's existing or future mines. Joint blending operations in China could begin within six months.
"This is not any strategy to try and exert control over the market. It's rather trying to capture value that exists there by creating a blend that ... we believe will suit our customers very nicely," Fortescue Chief Executive Nev Power told reporters.
The joint venture, which plans to blend 100 million tonnes a year of ore, or 10 percent of the volume China imported last year, will need approval from China's Ministry of Commerce.
Fortescue did not expect to run into any trouble with competition regulators, although analysts said opposition in China could be a big hurdle.
"There is no reduction in competition from this. If anything it improves the competitiveness of supply to the Chinese steel industry," Power said, adding that the companies had already started talks with regulators.
The China Iron & Steel Association said it was too early to comment on the deal as the details of how it would work had yet to be finalised.
Hunan Valin Iron & Steel Group, Fortescue's second largest shareholder with a 14 percent stake, is keen to see the product on the market, Power said. Hunan Valin could not be reached for comment.
Vale produces some of the world's highest grade iron ore, but has long complained it does not fetch the premium its high quality iron ore deserves in the international market.
Blending Vale's ore with lower quality material from Fortescue would bring the grade down to a more standard quality, and create a better sintering product for Chinese steel mills, replicating what traders and the mills now do for themselves.
"I think that selling both the ores independently means that we don't capture the full value of both those ores," Power said.
Citi analysts said the deal also helps Vale as it has the option of buying stakes in Fortescue's mines, protecting itself from potential challenges in securing environmental approvals for new mines in Brazil in the wake of the deadly Samarco dam disaster.
Vale is in the process of phasing out higher cost, lower quality production from its older mines in Minas Gerais state.
Fortescue, which has been racing to cut costs and slash debt to help weather the collapse in iron ore prices over the past two years, said it did not consider issuing new shares to Vale despite $6.1 billion net debt.
The company, controlled by founder and chairman Andrew "Twiggy" Forrest, has long been reluctant to water down Forrest's one-third stake and done everything it could to raise funds without issuing new equity.
Fortescue's shares initially rose nearly 7 percent to a 16-month high, adding to a stunning 24 percent gain on Monday when iron ore prices soared, but ended down 9 percent after weak China trade data revived worries about its economy.
Reporting by Stephen Eisenhammer in Rio de Janeiro and Sonali Paul in Melbourne; Additional reporting by Marcelo Teixeira and Reese Ewing in Sao Paulo; Editing by Richard Pullin