People's Bank of China Governor Zhou Xiaochuan Tuesday outlined plans to make the country's banking system better prepared for global competition by reducing the level of bad loans and lifting capital adequacy.

China's policymakers have been studying a plan that would both transfer a second tranche of nonperforming loans to asset management companies while also allowing the banks to raise sufficient new capital to bring their adequacy levels up to international standards.

In an interview with Zhou on the sidelines of a G20 meeting in Mexico carried on the official Xinhua News Agency, the central bank chief confirmed those plans, saying China has decided to reduce nonperforming assets and increase capital input into the banks.

Zhou also held up the reforms as a key step toward improving financial conditions within China to eventually allow a shift toward a more flexible exchange rate system for the yuan, also know as the renminbi.

"These measures won't only speed up commercial development (of the banks), motivate trade liberalization and promote the flow of capital in two directions, but also lay a good foundation for improving the system of exchange rates for the renminbi against other currencies in the future," Zhou said.

Zhou didn't provide specific details of the bank bailout plan. But analysts have said that improving the asset quality of the major state-run banks is a key prerequisite for eventual privatization.

Stabilizing China's financial system is also regarded as necessary to allow capital curbs to be eventually removed as a precursor to fully floating the yuan exchange rate.

UBS AG Economist Jonathan Anderson last week said that China needed to spend at least 2.8 trillion yuan ($1=CNY8.28) or 28% of gross domestic product to effectively reduce the nonperforming loan ratio of the four major banks to 12%.

That would double the CNY1.4 trillion in bad loans carved out of the four state banks and transferred to four asset management companies in 1999 as China's first attempt to rescue its banks from a legacy of debt built up under state planning.

China's Ministry of Finance also issued CNY270 billion in special treasury bonds in 1998 to recapitalize the banks up to the 8% capital adequacy ratio considered the international standard.

But this time, the banks might be allowed to issue their own debt to boost capital adequacy rather than rely on the Ministry of Finance, a strategy approved under international rules.

The China Banking Regulatory Commission is reportedly considering a change in bank laws that would allow the state banks to issue their own debt to replenish their capital base.

Zhou also reaffirmed the maintenance of China's stable yuan policy, but also added that capital controls will be gradually removed to eventually allow fully open capital account.

"China, on a reasonable and balanced basis, will continue to maintain the fundamental stability of the Chinese currency and will decentralize, in a selective and gradual way, the capital account so as to achieve capital account convertibility of the renminbi," Zhou said.

China is under intense international pressure to allow more flexibility in its exchange rate, but has argued that economic conditions and an undeveloped financial sector won't allow a sudden end to the de facto yuan-dollar peg.

China's leadership has, however, repeatedly reassured the U.S. of their commitment to a fully open capital account as a long-term objective.

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