By Karen Pierog

DETROIT (Reuters) - Detroit averted a financial meltdown after a Michigan judge on Wednesday dismissed a lawsuit that would have left the city without money it needs to make a key debt payment in two days.

Mayor Dave Bing called the episode, which threatened to cut off the city from state funds, an "unfortunate distraction". He said Detroit will be able to make a $34.2 million payment on its pension debt on Friday. Fears of an impending cash crunch had led to a cut in the city's credit ratings.

"Now it's time for the city to move forward," the mayor told reporters.

Detroit has been hard hit by a steep drop in population, years of severe budget deficits and escalating employee costs. Companies that once paid hefty taxes, including General Motors have reduced their presence in a city long synonymous with the auto industry.

In a tight 5 to 4 vote the city council in April approved a deal giving the state of Michigan greater control over Detroit's troubled finances while sidestepping a potential takeover by the state.

The deal was opposed by some council members because of the loss of independence it implies and the harsh spending cuts it is expected to impose.

Along with the deal, Michigan agreed to allow Detroit to raise $137 million through a bond sale to aid its tattered finances.

Detroit had faced a state funding cut-off after its top lawyer, Krystal Crittendon, earlier this month filed a lawsuit claiming that the financial stability agreement with the state was invalid because Michigan owes more than $230 million to Detroit and was in default to the city.

Ingham County Court Judge William Collette ruled that Crittendon could not bring the lawsuit because only Detroit's mayor and the city council have the authority to do so.

"This is such an obvious issue. I saw it from the moment it was filed," the judge said at a morning hearing in Mason, Michigan.

Crittendon's complaint was supported by some members of the Detroit City Council and was not initially contested by Bing. Crittendon could not immediately be reached for comment on whether she would appeal the ruling.

Kirsten Ussery, spokeswoman for City Council President Charles Pugh, said an appeal may not be possible.

"From what we understand, the corporation counsel could not legally appeal the decision without the mayor's approval, so the council is just moving forward," she said.

TALKS ON BOND ISSUE RESUMED

Bing said talks were held on Wednesday with Michigan officials about proceeding with the new bond issue that will include a restructuring of some outstanding city debt that had been put on hold because of the lawsuit over the financial stability deal.

Michigan Treasurer Andy Dillon said the ruling will allow the state and city to move ahead with the financial stability agreement.

"We continue to be focused on working with the mayor and CFO Jack Martin to help stabilize the city's finances and ensure citizens are receiving the services they deserve and expect," Dillon said in a statement. "Continued delays in moving this process forward only promise to make eventual solutions more difficult."

Uncertainty over the payment on the pension debt led Fitch Ratings on Tuesday to cut Detroit's credit ratings into the C category, signifying a greater chance of default. Standard and Poor's Ratings Services said on Wednesday that its B rating on Detroit remains unchanged as it expects the city to make the debt service payment in the wake of the lawsuit's dismissal.

It added it will continue to monitor the situation and take rating action as necessary should there be a change.

Bing said a financial advisory board created as part of the agreement with the state will meet on Friday even though the city council has not yet acted on its two appointments to the nine-member board because of the lawsuit.

Ussery said the council plans to meet on Thursday to make the appointments.

Meanwhile, the mayor on Wednesday named business executive William "Kriss" Andrews as Detroit's program management director. Under the financial stability agreement, the director is responsible for implementing government reforms aimed at improving the city's finances.

(Reporting by Karen Pierog, additional reporting by Aileen Wingblad in Mason, Michigan; Editing by Leslie Adler, Tiziana Barghini, James Dalgleish; Desking by Andrew Hay)