(Adds details, background, quotes)
* Encourages private money in banking sector
* Legalises overseas investments
* Wenzhou scheme may be expanded nationwide
By Zhou Xin and Lucy Hornby
BEIJING, March 28 (Reuters) - China's cabinet gave the go-ahead on Wednesday for a pilot project it hopes will one day form a cornerstone of nationwide financial sector reforms.
Private investors in the coastal city of Wenzhou will be encouraged to buy into local banks and to set up financial institutions such as loan companies and rural community banks, the State Council said in a statement posted on the government's website.
The city will also study allowing direct investments overseas by residents as part of a "general financial reform zone" experiment, a significant step toward liberalising capital account transactions.
Wenzhou, in eastern Zhejiang province, is known throughout China as a mecca for private entrepreneurship and grey-market lending.
In bringing private funds into the official banking system, Beijing is hoping that cash-starved small businesses, which are vital to employment in the world's second largest economy, will be able to access financing more easily and cheaply.
"Wenzhou private businesses are facing a lot of difficulties. A big flow of capital to SMEs will help resolve their financing problems," Zhou Dewen, head of the Wenzhou SME Association, told Reuters.
"This is the first step in Chinese financial reform. After this it will have to spread to all of Wenzhou and then elsewhere in China."
Allowing private investors to lend via legal entities will help Beijing tame the country's underground lending market, where annualised interest rates can reach 100 percent. 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.
Many private businesses are forced to turn to 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.
The idea for a financial reform zone emerged in late 2011 after media reports on Wenzhou entrepreneurs who had gone into hiding or committed suicide after they were unable to repay high interest under-the-counter loans.
The local central bank branch estimates underground lending in Wenzhou at 110 billion yuan. About a third of that is used for real economic activities with the rest going to speculative investments, according to local media reports.
"The problem now is on the one hand, many small and tiny businesses are in bad need of money, but on the other hand, banks can't satisfy their demands," Chinese Premier Wen Jiabao told reporters earlier this month, in response to a question about Wu Ying, an entrepreneur from Zhejiang now on death row.
The young woman was sentenced to death by a local court for "illegally raising" 770 million yuan in funds. The case, currently under review by the Supreme Court, became a cause celebre as many in China argued that Wu's private lending and borrowing activities should be protected, not punished, by the government.
As part of the pilot reform in Wenzhou, residents there may also be formally allowed to invest abroad directly, a significant step toward liberalising capital account transactions.
China's once-rigid foreign exchange management system, which largely discouraged companies and individuals from holding foreign currencies, has contributed to China accumulating up $3.2 trillion in forex reserves, the largest such pile in the world.
If implemented, the resident foreign investment provision would create a new channel for Chinese retail investors to gain exposure to overseas financial assets, outside the existing Qualified Domestic Institutional Investor (QDII) programme.
"It's in line with the overall national strategy of balancing capital inflows and outflows," said Yi Xianrong, a researcher with the Chinese Academy of Social Sciences (CASS), a government think-tank in Beijing.
The Wenzhou municipal government issued rules in early 2011 allowing overseas financial investment by Wenzhou residents, but scrapped them two weeks later when the State Administration of Foreign Exchange intervened.
In practice, Wenzhou's asset-hungry investors had already gone abroad. Some even counted among the real estate investors hurt by Dubai's property crash.
It is common practice for Beijing to try complicated reforms in designated areas before rolling them out nationwide.
China's former paramount leader Deng Xiaoping made the southern boomtown of Shenzhen the country's first "special economic zone" open to foreign investments in the late 1970s, when it was just a small village.
In the Wenzhou programme, other listed plans include measures for regulating the local private lending market, boosting the private equity sector, and encouraging financial products designed for small businesses.
"(The reforms) are not only important for Wenzhou but also meaningful for the whole country's financial reform and economic development," the State Council said, concluding a routine meeting.
The State Council said the approval would serve as a guideline and that the Zhejiang provincial government should work out detailed measures.
Yi from CASS said the guidelines for Wenzhou have shied away from a key issue in financial reform.
"Interest rate reform is not listed, although pricing is a core issue for any financial reform," Yi said.
"If the established banks don't change their practices, then a supplementary private banking system, even if it is legalised, won't make a big difference," he added. (Additional reporting by Michael Martina; editing by Stephen Nisbet)