China's State Council, or cabinet, last week said it would study allowing direct investments overseas by residents in the eastern Chinese city of Wenzhou as part of a "general financial reform zone" experiment. That was seen as a significant step toward liberalizing capital account transactions.

Speaking at the 2012 Boao Forum for Asia on China's southern Hainan island, central bank head Zhou Xiaochuan said China encouraged capital outflows, which would help reduce imbalances caused by net capital inflows.

"There may be further deregulation to allow Chinese enterprises and residents more convenience in (making) overseas investment," Zhou said, without saying whether any reforms would be limited to Wenzhou or expanded to other areas.

Zhou also warned that the global economy could slip back into recession, and reiterated that China would use a combination of monetary tools to tackle inflation and steer towards a soft landing.

"We are still in the global financial crisis period, there are new elements that may bring the global economy back to recession," he said.

China's central bank is seen as on track to ease policy as the world's second-largest economy encounters stiff global headwinds, but it has stuck to a gradual approach due to concern over inflation and property risks.

Annual economic growth is widely expected to slow to just over 8 percent in the first quarter of 2012 - the fifth consecutive quarter of lower pace expansion - while annual inflation cooled to a 20-month low of 3.2 percent in February.

Wenzhou, in Zhejiang province, is known throughout China as a hub for private entrepreneurship and 'grey market' lending.

Many private businesses are forced to turn to so-called grey market lending because they lack the connections to access loans at official rates, which primarily flow from state owned banks to state owned enterprise.

Allowing private investors to lend via legal entities will help the government tame the country's underground lending market, where annualized interest rates can reach 100 percent.

The idea of a financial reform zone emerged in late 2011 after media reports about Wenzhou entrepreneurs who had gone into hiding or committed suicide after they were unable to repay high interest under-the-counter loans.

The People's Bank of China estimated that market at 2.4 trillion yuan as the end of March 2010, or 5.6 percent of China's total lending.

ROOM FOR A BRICS LENDER

China's plans to introduce a deposit insurance system to protect depositors from losses caused by banking failures have been delayed by the global financial crisis, Zhou said.

Such an insurance system is also seen as a foundation for interest rate liberalization, as a market-oriented interest rate would end the banks' built-in interest rate margin, and could put depositors at risk.

Earlier this year, Zhou told state media that the government has made "effective" preparations and would introduce the deposit insurance system at an appropriate time.

Zhou also defended a plan by the BRICS group of emerging economies to establish a joint development bank that would act as an alternative lender to the World Bank, saying the plan was feasible and would not compete with existing lenders.

There is room for such a bank because the performance of existing regional development lenders in helping emerging economies to cope with the global financial crisis had "not met expectations", he said.

Last week, World Bank president Robert Zoellick said the plan would have a hard time getting started and would struggle to match the expertise of the World Bank, which is traditionally led by the United States.

(Reporting by Kevin Yao, Writing by Michael Martina; Editing by Don Durfee, Robert Birsel and Daniel Magnowski)

• A Permanent Economic Emergency