BEIJING (Reuters) - Inflation and asset bubble risks could increase sharply in China, and counter-cyclical loan controls are needed as a line of defence, central bank governor Zhou Xiaochuan said in comments published yesterday.

China, which saw its banking system come through the global financial crisis largely unscathed, is grappling with a raft of potential dangers, Zhou said.

The comments were made at a conference on Monday in Shanghai, a day before the central bank surprised investors and analysts with its first interest rate increase in nearly three years.

"Domestic credit expansion still remains strong. There are potential risks from cross-border capital flows. Macro-economic risks linked to excessive liquidity, inflation, asset bubbles and a cyclical rise in bad bank loans are rising significantly," he said.

"The establishment of a counter-cyclical credit mechanism is the focus of China's efforts to strengthen its macro-prudential policies," he said. To a certain extent, China has already gone down the path of counter-cyclical loan controls.

In 2009 banks answered the government's call to lend more and unleashed a record 9.6 trillion yuan ($1.4 trillion) flood of new credit, a crucial part of China's stimulus programme in the face of the global financial turmoil

The government has this year tried to steer monetary conditions back to normal and imposed tighter lending restrictions on banks. The full-year target for new lending was set at 7.5 trillion yuan.

Chinese banks have also been told to scale back lending to property developers and debt-ridden local governments.

A record jump in China's foreign exchange reserves in the third quarter has raised concerns of a rise in hot money inflows, but analysts say Beijing will avoid imposing any new Draconian measures to restrict cross-border capital.